Deflation is the general decrease in the prices of goods and services within an economy at a specific period.
According to the International Monetary Fund (IMF), Deflation is defined as a sustained decline in an aggregate measure of prices, such as the Consumer Price Index (CPI) or the GDP deflator. Deflation increases the value of a currency in the Forex market and boosts consumers’ purchasing power. Deflation was first recorded during the Industrial Revolution in the 19th century (1870s) during the great deflation.
Deflation is caused by low demand and oversupply of goods and services. Monetary policies from central banks can cause deflation. For instance, high interest rates or reduced money supply in an economy can trigger deflation. Central banks respond to deflation by implementing deflationary policies aimed at reversing deflation and maintaining moderate inflation.
Monetary deflation, debt deflation, cost-push deflation, demand-pull deflation, secular and structural deflation are the types of deflation. Deflation has occurred in the economies of Japan, Greece, Switzerland, China, the Eurozone and many other places in the world at different times.
Prolonged Deflationary pressure on an economy comes with the disadvantages of lower sales, lower revenues, retrenchments, unemployment and economic downturn. Good deflation has the advantages of increased currency value, lower production costs, technological progress and improved savings culture.
What is Deflation?
Deflation is an economic situation where the prices of goods and services are declining over a period of time. Deflations boost the value of the currency by increasing the purchasing power of consumers but reducing the sales and profits of businesses. An economy is in deflation when the inflation rates drop below 0%.
Deflation means a downward movement in the price level of goods and services in an economy. Deflation appears to be a good phenomenon in the short term, but long periods of deflation will adversely affect the growth of an economy. Consumers benefit from deflation, while debt holders are hurt by deflation because it increases their debt burden.
Higher purchasing power and lower prices are what happens in deflation. The money in the hands of consumers is capable of purchasing more goods and services than it could previously buy. The currency has gained more value when compared to other currencies. Businesses suffer as lower prices contract their revenue which leads to lower wages, retrenchments, and job losses. Consumer and business confidence dwindles as the economy slows down, which prompts the government and its agencies to respond.
Monetary economists assert that ‘control of money supply is crucial to economic stability’. Government bodies and Central banks monitor and control deflation in their economies by identifying the cause and finding solutions. For instance, Central banks increase the money supply during deflation by buying assets from the open market, decreasing the reserves of commercial banks, and increasing interest rates to stimulate the economy and encourage spending.
The strengthening of a currency due to deflation affects its exchange rates in the Forex market and the financial markets in general. Deflation is a Forex terminology used by Forex traders to analyze the strength of the currency of an economy. Forex traders monitor deflation and incorporate it into their trading strategies.
Deflation is measured with the same Consumer Price Index (CPI) used to measure inflation. Experts create a basket of basic goods and services frequently bought by most households in the economy and aggregate their prices as an index. The rate of change in the index is compared monthly, quarterly, or yearly and expressed as a percentage. Deflation occurs if the inflation rate is negative for a chosen period.
What is Deflation in Economics?
Deflation in economics is defined as a decrease in the general price level of goods and services. Deflations arise when the nominal costs of goods and services reduce with time. Economists worry about long-term deflation as it is a precursor to recession, which is bad for any economy.
During a deflation in economics, high supply and low demand drive the prices of goods and services lower than their actual values. Businesses continue to reduce their prices as they desperately struggle to get consumers to purchase their products. Consumers are happy because prices are lower and they can buy more with less funds.
Long-term deflation leads to recession, which is a period of economic slowdown characterized by job losses, declining wages and investments. John Maynard Keynes, a renowned British economist, believes that “Deflation exacerbates economic downturns, reducing aggregate demand.”
What is the History of Deflation?
The history of deflation can be traced to the ‘great deflation’ of the 1870s when prices consistently dropped due to industrialization. Deflation was recorded in the early 1930s during the great depression, and played a major role in the Japanese lost decades.
Deflation was first documented during the great deflation period (1870 – 1890). The Great Deflation was a period of mild but sustained deflation in the US, Europe, and the Western world. 2% deflation was recorded annually. The Great Deflation started at the beginning of the Second Industrial Revolution, where the industrialization of agriculture led to cheaper raw materials and lower prices, which triggered the deflation. Commodities were mass-produced and transported via railways.
Deflation was recorded during the great depression, which was a severe economic downturn experienced in the Western world from 1929 to 1933. Demand for goods and services dropped, and unemployment surged. The world’s GDP contracted by 15%, and the US CPI fell by 27%, according to the US Bureau of Labor Statistics. International trade compressed by 67%, as in 1933, when the recession ended. Milton Friedman, an American economist and Nobel laureate, insists that the great depression resulted from monetary policy failure.
The Lost Decades refer to Japan’s long period of economic stagnation spanning 3 decades from 1991 to 2021. Deflation started in 1992 after the bursting of the ‘asset price bubble’ where real estate and stock prices were inflated beyond their real values. Deflation caused the Japanese Yen to gain more value, which forced businesses to cut salaries, and small businesses shut down operations as they preferred to hold onto available cash. By 2016, the Bank of Japan (BoJ) introduced a negative interest rate of -0.1% to encourage borrowing and spending since borrowers will pay less than what they borrow. The Japanese deflation was reversed in 2021 when the post-COVID-19 pandemic inflation started all over the world.
What Causes Deflation?
Deflation is caused by an overall growth in the supply of goods and services, an aggregate decrease in demand, changes in consumer sentiments within the economy, and monetary policies by the central bank or government.
Increases in the supply of goods and services without a corresponding increase in demand cause deflation. Importation and lower cost of raw materials are the factors that lead to increased supply. Competition among sellers or producers of goods and services leads to lower prices, which results in deflation.
Improved production powered by technological advancements, automation, or innovations results in deflation. Tech advancements and automation lower production costs and increase production. Increased production with unchanged demand will result in lower prices.
Sudden drops in demand cause inflation. Negative economic events, lower wages, and unfavorable government policies are some of the factors that cause a decline in the demand for products and services.
Declining consumer confidence, occasioned by recessions, pandemics, and wars, triggers deflation. Unfavorable events create emotions like fear of losses, which will make consumers save more and spend less, thereby beckoning deflation.
Reduced money supply or slow circulation of money in an economy leads to deflation. High interest rates by Central banks discourage borrowing, lending, and spending, which slows down the economy and causes deflation. A financial crisis like a bank failure decreases the money available for circulation in an economy and causes deflation.
Deflation happens when producers and sellers of goods and services continue to reduce their prices in response to declining demands or excessive supply. Merchants must have to sell at lower prices to retain clients, maintain liquidity, and remain competitive.
What are the Effects of Deflation?
The effects of deflation are listed below.
- Low prices: Deflation causes a general reduction in prices of goods and services offered by businesses, which translates to reduced income. Businesses are left with unchanged expenses but reduced capital.
- Reduction in consumer spending: Consumers postpone purchases in anticipation of continued lower prices.
- Decline in investments: Investors avoid economies undergoing deflation because there are high chances of suffering losses. Investors prefer to keep their funds since it is gaining value by the day while asset values decline.
- Unemployment: Long-term deflation causes high unemployment rates because decreased sales translate to decreased profits. Retrenchments and cost reduction are the immediate response to reduced revenue by both small and large businesses.
- Increases debt burden: Deflation increases the value of debts because the currency now has greater value. Households who owe mortgages and businesses owing bank loans find it difficult to pay back.
- Low business growth: Businesses will not invest in capital expenses since they are anticipating lower sales and lower prices. Deflation causes the delay or outright postponement of innovations and technological upgrades.
- Deflationary Spiral: A deflationary spiral is a situation where declining prices lead to lower wages, lower production, and unemployment, further worsening the economic downturn. A negative loop of worsening economic conditions defines a deflationary spiral, occasioned by deflation.
- Policy interventions: Deflation economics principles of ‘Monetarism’ believe that deflation is caused by reduced money supply in the economy. The government and Central banks battle deflation in the economy by implementing monetary policies that will increase money supply, increase demand, raise prices and stimulate economic growth.
How Does Deflation Affect Forex Trading?
Deflation affects Forex trading by increasing the strength of currencies from affected economies. Deflations affect Forex trading by changing exchange rates and evoking statements and restrictive measures from policymakers. Forex traders incorporate deflation into their trading strategies as they actively monitor fundamental data.
Deflation impacts the Forex market by causing volatility in the prices. A currency from an economy under deflation gives Forex traders information about the price movement or exchange rate direction. For instance, if the Japanese economy is experiencing deflation and the JPY grows stronger, the USD/JPY exchange rates will decline because less JPY is needed to buy the USD. Deflation in Japan will cause the JPY/MXN currency pair to appreciate because more MXN will be required to exchange for the strong JPY.
Deflations are undesirable economic situations that prompt policymakers to respond with measures to curb the effects. Forex traders constantly monitor periodic economic releases, monetary policies, and statements from government and central bank executives across the world. Updated deflation data are incorporated into Fx trading through trading strategies developed by Forex traders to predict the next price movement of the affected currency pairs.
How do Forex Traders Handle Deflation?
Forex traders handle deflation by following the economic releases involving deflation and other fundamental data, then analyzing the data with respect to their trading strategies in order to make trade decisions. Forex traders move to safe-haven currencies and diversify their portfolios in times of uncertainties brought about by deflation.
Forex traders spend time monitoring and analyzing the fundamental data that moves the Forex market. Deflation-sensitive economic indicators monitored by Forex traders are Consumer Price Index (CPI), Gross Domestic Product (GDP), interest rates, and unemployment rates. Forex traders adapt their trading strategies to accommodate changing market conditions fostered by deflation.
FX traders anticipate response to deflation by policymakers and incorporate it into their trading strategies. For instance, some Forex traders may open a trade position in the market in anticipation of a response to deflation by the central bank, while other traders delay entry until after the response.
Flight to safe-haven currencies is a way for Forex traders to handle deflation. Safe-haven currencies are currencies owned by stable economies. Safe-haven currencies always maintain their values in times of economic turbulence, wars, and geopolitical tensions. Forex traders handle deflation by avoiding currencies from nations going through deflation and focusing on safe-haven currencies. Some safe-haven currencies are USD, CHF, and JPY.
Diversification of assets is a risk management strategy deployed by Forex traders to curb the risks posed by deflation. Trading commodities like Gold, futures, ETFs, and spreading their capital over different asset classes help Forex traders protect their investment capital in times of deflation and its attendant uncertainties.
Is Deflation Good for Investors?
No, deflation is not good for investors because it reduces the value of their assets while increasing the value of money or cash in the economy. Long-term deflations force investors to liquidate their investments as they continue to lose their values.
Deflation is not good for investors if it is sustained for a long time because it causes the value of assets to decline. Lower prices decrease the profits of businesses, which results in a decline in stocks, bonds, and the financial markets. Prices of real estate and commodities continue to fall, leaving investors with losses.
Investors convert their assets to cash in times of prolonged deflation, since the value of money is increasing while the values of assets continue to decline. Investors in small-scale businesses, stock market, and bonds sell them off because they find no reason to continue to hold these assets as their worth continues to depreciate.
Do Forex brokers provide deflation news for traders?
Yes, Forex brokers provide deflation news for traders on their websites, e-mail, newsletters, trading platforms and mobile apps. Forex brokers partner with Forex news portals, Forex research experts, and analysis firms to provide traders with deflation news, market news, and other important services.
Forex brokers stream real-time market news and analysis on their websites, trading platforms, and mobile apps. The economic calendar is also provided on multiple channels. An economic calendar features times, dates, impact levels, news, history, and other data about economic events that usually affect the Forex market. Fundamental analysts use the economic calendar in their analysis of the Forex market. For instance, the economic calendar will give details on the time when deflation-related economic indicators of a currency will be available.
Forex brokers of smaller size or limited resources often partner with expert news, research, and analysis providers to furnish traders with deflation news and other services. In-depth market analyses, and news on deflation-related economic indicators like CPI, PPI, GDP, interest rates, and unemployment rates are provided by Forex brokers via partner portals and apps. Traders are given weekly outlooks, trading insights, trading ideas, signals, and trading education.
What are the Types of Deflation?
The types of deflation are listed below.
- Demand-pull deflation or bad deflation: Demand-pull deflation happens when the aggregate demand in an economy declines while the supply remains the same. Decreased consumer spending and reduced production characterize demand-pull deflation. Bad deflation leads to job losses and economic downturns.
- Cost-push deflation or good deflation: Cost-push deflation occurs when production costs reduce, supply increases and prices of products fall. Technological advancements, automation and industrialization are some of the factors that drive cost push or good deflation.
- Monetary deflation: Monetary deflation is caused by reduced money supply within the economy. Monetary inflation is characterized by a reduction in economic activities such as lending, spending and borrowing.
- Debt deflation: Debt deflation is caused by excessive debts in an economy. Deflation increases the debt burden, which makes it difficult to pay back loans. Consumers and businesses resort to spending very little money on essential needs in order to continue servicing outstanding debts.
- Structural deflation: Structural deflation occurs when fundamental changes are recorded in the economy. For instance, a shift from a consuming to a production economy induces structural deflation.
- Secular deflation: Secular stagnation occurs when prices of goods and services decline due to a lack of sustained demand. Aging population is one of the factors that lead to secular deflation. For instance, economies that have developed high-level production courtesy of improved technology, but do not have the population or resources to sustain demand are at risk of secular population.
What are the Advantages of Deflation?
The advantages of deflation are listed below.
- Increased purchasing power: Consumers are able to buy more goods and services because the value of the currency has strengthened.
- Low production costs: Good deflation involves lower prices driven by reduced production costs arising from technological advancement or industrialization. Lower production costs improve global competitiveness, which leads to exports and foreign exchange revenue.
- Technological progress: Good deflation driven by technological advancements, efficient production and distribution mechanisms helps the economy to grow. Increased productivity and reduced prices will eventually aggregate to wider profit margins and stock growth.
- Saving culture: Deflation promotes the saving of money and discourages frivolous spending. For instance, consumers find it difficult to go on vacation using credit cards in times of deflation, because vacation is not a necessity and paying back will be difficult.
Who Benefits from Deflation?
Deflation benefits consumers as their purchasing power is increased. Deflations favor savers who hold cash in bank accounts because their money has a higher value. Lenders benefit from deflation because they receive a higher real value of their fixed interests. Export companies make more profits in times of deflation.
Deflation benefits consumers by giving more value to the money in their custody. Individuals and businesses make more purchases with less funds as prices of goods and services drop in the economy.
Deflation increases the value of savings owned by individuals and businesses. Cash in home safes, bank accounts, and retirement savings accounts increase in value in times of deflation. Savers capitalize on deflationary lower prices to purchase expensive assets that were out of reach prior to deflation.
Banks, credit unions, credit card institutions, and other lenders benefit from deflation because they receive a higher real interest rate during deflations. For instance, if the interest rate on a loan is 8% and the expected inflation rate is 2%, then the real interest rate expectation will be 6%. However, when deflation occurs and the inflation rate becomes -1%, the real interest rate expectation becomes 9%.
Export firms become more competitive when deflation sets in. The stronger currency from the deflationary economy exchanges for more foreign exchange when the goods are exported.
What are the Disadvantages of Deflation?
The disadvantages of deflation are listed below.
- Low production: Businesses respond to lower sales by cutting production to avoid wastage and unnecessary expenses.
- Low income and low profits: Companies are unable to keep up with the payment of wages when sales are low and revenues are declining, as a result, salary cuts are the next option. Entrepreneurs record lower sales, smaller profit margins and decreased earnings.
- Unemployment: Reduced sales translate to reduced profits and reduced wages. Businesses lay off staff to reduce costs and remain in business.
- Reduced investments: Individual and corporate investments are one of the drivers of economic growth. Deflation forces investors to liquidate their assets in order to salvage their capital from further losses.
- Economic downturn: Lower sales, lower profits, fewer jobs and reduced spending ultimately culminate into economic downturns or recessions in an economy.
- Deflationary spiral: Deflation triggers a negative spiral loop, which makes the economic situation worse as sales are low, unemployment is growing and the overall demand and spending are still low. Uncertainty sets in and spending grows weaker, worsening the economic condition.
Why is Deflation bad?
Deflation is bad because it slows down the economy and ultimately leads to a recession. Deflations discourage business expansions, investments, and overall spending because keeping cash becomes beneficial as its value is high. Deflation increases the real debt burden and makes it difficult to repay loans, mortgages, and borrowed funds.
Bad deflation is brought about by negative factors such as low money supply and reduced demand for goods and services. Bad deflation can damage the economy when sustained over long periods of time.
Deflation causes reduced income, loss of jobs, and increases unemployment rates in an economy. Declining prices and weak demand aggregate to low sales and low income. Companies reduce their workforce or even shut down as they struggle with declining revenues.
Existing loans become very difficult to pay back in times of deflation because the value of the currency has appreciated. Banks record more defaults in mortgage and loan repayments, as more consumers become insolvent and declare bankruptcy.
Who Suffers most from Deflation?
Debtors suffer most from deflation because the debt burden is increased. Small business owners suffer from little or no profits during deflation. Unemployed and underemployed continue to suffer hardship and hopelessness as there are very few or no job openings.
Indebted individuals, businesses, and investors are hurt by deflation because the real value of their debt increases. Existing debts become difficult to pay back as they are to be repaid with a higher-value currency. Governments owing high debts suffer because revenues are low and the debt burden is increasing.
Small and medium-sized enterprises (SMEs) are affected negatively by deflation because their profits are greatly reduced by low sales and low prices. Deflation is a period of uncertainty for SMEs as total expenses are unchanged, profits are dwindling, and taking a loan is unreasonable. SMEs suffer from deflation as they struggle to stay afloat.
Prolonged deflation hits hard on unemployed or underemployed people looking for better job opportunities. Companies cut costs and reduce staff strength which further worsens the plight of the unemployed and dampens their hopes of landing a job.
What are Examples of Deflation?
Some deflation examples are listed below.
- Japanese deflation: Japan experienced slow economic growth marked by deflation from the early 1990s. The Japanese deflation was attributed to an aging population, insolvent banks, and the importation of cheap goods from China. The Bank of Japan actively responded with monetary policies that yielded little results. Deflation returned and persisted from 2009-2014.
- The Great Recession: Deflation was experienced in the US during the Great Recession (2007 – 2009). The drop in the prices of commodities was seen around the world in 2009 which led to deflation.
- Eurozone deflation: Some European countries experienced deflation from 2013-2016. For instance Greece, Bulgaria, Cyprus, Spain and Slovakia all experienced deflation from 2014-2016.
- Greece deflation: The Greek economy suffered deflation for 29 months from 2014 – 2016. The deflation peaked in November 2013 when it dropped 2.9% year-on-year.
- Switzerland deflation: Switzerland experienced deflation from 2011 to 2015. The deflation was caused by a strong Swiss Franc, weak domestic demand, the Eurozone debt crisis and the monetary policies implemented by the Swiss National Bank (SNB).
- Chinese deflation: China suffered deflation in 2015-2016 when producer prices declined. Weak domestic demand, falling prices and the stock market crash of 2015 contributed to the deflation which contracted the PPI by 5.2%.
Can Central Banks Control Deflation?
Yes, Central banks can control deflation by implementing monetary policies aimed at tackling deflation. Reducing interest rates in an economy affects deflation because borrowing money becomes cheaper. Reducing bank reserves can also control deflation. Quantitative easing is a policy used by central banks to control deflation.
Low interest rates encourage consumers to take student loans, mortgages, and multiple loans from credit institutions. Deflation is controlled by central banks through reduction of interest rates, which makes it cheaper or even free to borrow funds from credit card institutions, credit unions, or banks.
Reducing the bank reserves of commercial banks lowers deflation as it makes more money available for loans. Central banks fix a certain amount as reserves for commercial banks, which they can lower to control deflation. For instance, the US Fed reduced bank reserves to 0% in March 2020 in order to increase liquidity in the economy, in the heat of the lockdown occasioned by the COVID-19 pandemic.
Quantitative easing is a measure used by central banks to control deflation. Quantitative easing is a monetary policy in which central banks purchase securities from the open market. Quantitative easing increases the money supply, encourages lending, supports investments, and stimulates the economy. Injecting funds into the economy improves the liquidity of commercial banks and lowers interest rates.
What is the difference between Deflation and Inflation?
The difference between deflation and inflation is that deflation is characterized by a downward movement of the prices of goods and services, while inflation is the upward movement of prices. Inflation favors debtors, investors, and the overall economy, provided it is moderate, while deflation favors consumers in the short term but poses a threat to economic growth.
The “deflation vs inflation” dynamics represent two economic forces moving in opposite directions. Deflation is a period in an economy where prices of goods and services are declining as a result of a drop in demand, or excess supply of goods and services. Inflation is characterized by a general increment in prices driven by a shortage in supply or a surge in demand.
Deflation is caused by excessive supply, which stems from technological advancement, industrialization, or improved supply chain, while inflation is triggered by disruptions in supply chains, natural disasters, or high cost of raw materials.
Monetary policies by central banks or government interventions can cause either deflation or inflation. For instance, an inadequate supply of money leads to deflation, while oversupply triggers inflation. High interest rates cause deflation while low interest rates lead to inflation.
The burden of debtors is increased by deflation. Debtors struggle to pay with a stronger currency of higher value. Inflation reduces the debt burden because the currency is weaker and debts are repaid easily with low-value currency.
Deflation favors consumers as prices are low, while inflation adversely affects consumers, especially fixed-income earners. Persistent deflation stunts economic growth and leads to recessions, while moderate inflation encourages spending, investments, and stimulates economic growth.