Deflation

What Is Deflation?

Deflation is a broad and persistent fall in prices across an economy. Prices for most goods and services, tracked by a price index such as the consumer price index, decline over an extended period. When deflation occurs, each unit of currency gains purchasing power. It differs from a brief drop in the price of one product, which is not deflation. Deflation refers to a general, sustained trend.

What Causes Deflation?

Deflation usually stems from one of two broad sources. The first is weak aggregate demand. When households and businesses spend less, sellers cut prices to attract buyers. The second is an increase in supply or productivity. When producing goods becomes cheaper, competition can push prices down. Tight monetary policy can also contribute, because a shrinking supply of money and credit makes it harder for spending to keep pace with the economy's capacity to produce.

Why Deflation Matters to Investors

Deflation can create a difficult feedback loop. Consumers may postpone purchases because they expect prices to be lower later, which reduces demand further. Businesses facing lower revenue may cut costs or wages. Companies and households carrying debt find repayment harder, because the real value of that debt rises as prices fall. Economists call this debt deflation. Central banks often treat persistent deflation as a problem because it limits their ability to stimulate the economy by lowering interest rates once those rates are already near zero.

Historical Examples

Deflation has occurred in several economies. The United States saw steep price declines during the Great Depression of the 1930s, and Japan spent many years from the late 1990s into the 2000s with falling or flat prices. Economists generally regard these episodes as costly, though they disagree about how much of the damage came from deflation itself and how much came from the broader downturns that accompanied it.