US & World Economies Economic Terms Deflation, Its Causes, and Why It's Bad Deflation threatens you more than inflation By Kimberly Amadeo Kimberly Amadeo Kimberly Amadeo is an expert on U.S. and world economies and investing, with over 20 years of experience in economic analysis and business strategy. She is the President of the economic website World Money Watch. As a writer for The Balance, Kimberly provides insight on the state of the present-day economy, as well as past events that have had a lasting impact. learn about our editorial policies Updated on March 4, 2021 Reviewed by Charles Potters Reviewed by Charles Potters Charles is a nationally recognized capital markets specialist and educator with over 30 years of experience developing in-depth training programs for burgeoning financial professionals. Charles has taught at a number of institutions including Goldman Sachs, Morgan Stanley, Societe Generale, and many more. learn about our financial review board Share Tweet Pin Email In This Article View All In This Article Measuring the Decline Causes Deflation's Cautionary Tale How It’s Stopped Deflation Is Worse Than Inflation Times When Deflation Is Good Japan: A Modern Example Frequently Asked Questions (FAQs) At first, deflation seems like a good thing to consumers as prices are lowered. Photo: Photo by Mario Tama/Getty Images Deflation occurs when asset and consumer prices fall over time. While this may seem like a great thing for shoppers, the actual cause of widespread deflation is a long-term drop in demand. Deflation often signals an impending recession. With a recession comes declining wages, job losses, and big hits to most investment portfolios. As a recession worsens, so does deflation. Businesses set ever-lower prices in desperate attempts to get consumers to buy their products and services. Key Takeaways Deflation occurs when the prices of goods and services fall.Deflation expectations make consumers wait for future lower prices. That reduces demand and slows growth. Deflation is worse than inflation because interest rates can only be lowered to zero.Innovation can cause good deflation. Measuring the Decline Deflation is measured by a decrease in the Consumer Price Index, but the CPI does not measure stock prices, an important economic indicator. For example, retirees use stocks to fund purchases. Businesses use them to fund growth. In other words, when the stock market drops, the CPI might be missing one important indicator of deflation as it's felt in people's pocketbooks. Comprehensive awareness of this economic indicator is important for effectively gauging whether or not a dramatic dip in the stock market will cause a recession. Neither does the CPI include sales prices of homes. Instead, it calculates the "monthly equivalent of owning a home," which it derives from rents. This is misleading since rental prices are likely to drop when there is a high vacancy. That's usually when interest rates are low and housing prices are rising. Conversely, when home prices are dropping due to high-interest rates, rents tend to increase. Note CPI figures can provide a false low reading when home prices are high and rents are low. This is why asset inflation during the housing bubble of 2006 went essentially unnoticed. Had it been a focus, the Federal Reserve could have raised interest rates in an attempt to prevent the bubble. Such a strategic response might have also mitigated some of the pain when the bubble burst in 2007. Causes There are three reasons why deflation exists as a greater threat than inflation since 2000. First, exports from China have kept prices low. The country has a lower standard of living, so it can pay its workers less. China also keeps its exchange rate pegged to the dollar, which keeps its exports competitive. Second, in the 21st century, technology such as computers keeps workers' productivity high. Most information can be retrieved in seconds from the internet. Workers don't have to spend time tracking it down. The switch from snail mail to email streamlined business communications. Third, the excess of aging baby boomers allows corporations to keep wages low. Many boomers have remained in the workforce because they can't afford to retire. They are willing to accept lower wages to supplement their incomes. These lower costs mean companies haven't needed to raise prices. Deflation's Cautionary Tale Deflation slows economic growth. As prices fall, people put off purchases. They hope they can get a better deal later. You've probably experienced this yourself when thinking about getting a new cell phone, iPad, or TV. You might wait until next year to get this year's model for less. This puts pressure on manufacturers to constantly lower prices and to develop new products. That's good for consumers like you, but constant cost-cutting means lower wages and less investment spending. That's why only companies with a fanatic, loyal following, like Apple, really succeed in this market. Note Massive deflation helped turn the 1929 recession into the Great Depression. As unemployment rose, demand for goods and services fell. The Consumer Price Index fell 27% between November 1929 to March 1933, according to the Bureau of Labor Statistics. As prices fell, companies went out of business. More people became unemployed. When the dust settled, world trade had essentially collapsed. The volume of goods and services traded fell 67%, from $3 billion in 1929 to $992 million in 1933. How It’s Stopped To combat deflation, the Federal Reserve stimulates the economy with expansionary monetary policy. It reduces the fed funds rate target and buys Treasurys using its open market operations. When needed, the Fed uses other tools to increase the money supply. When it increases liquidity in the economy, people often wonder whether the Fed is printing money. Our elected officials can also offset falling prices with discretionary fiscal policy, or lowering taxes. They can also increase government spending. Both create a temporary deficit. Of course, if the deficit is already at record levels, discretionary fiscal policy becomes less popular. Note Why does expansionary monetary or fiscal policy work in stopping deflation? If done correctly, it stimulates demand. With more money to spend, people are likely to buy what they want as well as what they need. They'll stop waiting for prices to fall further. This increase in demand will push prices up, reversing the deflationary trend. Why Deflation Is Worse Than Inflation The opposite of deflation is inflation. Inflation is when prices rise over time. Both economic responses are very difficult to combat once entrenched because people's expectations worsen price trends. When prices rise during inflation, they create an asset bubble. This bubble can be burst by central banks raising interest rates. Former Fed Chairman Paul Volcker proved this in the 1980s. He fought double-digit inflation by raising the fed funds rate to 20%. He kept it there even though it caused a recession. He had to take this drastic action to convince everyone that inflation could actually be tamed. Thanks to Volcker, central bankers now know the most important tool in combating inflation or deflation is controlling people's expectations of price changes. Note Deflation is worse than inflation because interest rates can only be lowered to zero. Once rates have hit zero, central banks must use other tools, but as long as businesses and people feel less wealthy, they spend less, reducing demand further. They don't care if interest rates are zero because they aren't borrowing anyway. There's too much liquidity, but it does no good. It's like pushing a string. That deadly situation is called a liquidity trap and is a vicious, downward spiral. The Rare Times When Deflation Is Good A massive, widespread drop in prices is always bad for the economy, but deflation in certain asset classes can be good. For example, there has been ongoing deflation in consumer goods, especially computers and electronic equipment. This isn't because of lower demand, but because of innovation. In the case of consumer goods, production has moved to China, where wages are lower. This is an innovation in manufacturing, which results in lower prices for many consumer goods. In the case of computers, manufacturers find ways to make the components smaller and more powerful for the same price. This is technological innovation. It keeps computer manufacturers competitive. Japan: A Modern Example Japan's economy has been caught in a deflationary spiral for the past 30 years. It started in the late 1980s when Japan's housing bubble burst. Japanese people became savers. When they saw the signs of recession, they stopped spending and put away funds for bad times. They assumed that wages and prices will not rise, so it's better to save. Banks invested the extra funds in government debt instead of new business ventures. A study by Daniel Okimoto at Stanford University identified four other factors contributing to this longstanding spiral: The political party in power did not take the difficult steps needed to spur the economy. Taxes were raised in 1997. Banks kept bad loans on their books. This practice tied up the capital needed to invest in growth. The yen carry trade kept the value of Japan's currency high relative to the dollar and other global currencies. The Bank of Japan tried to create inflation by lowering interest rates, but traders took advantage of the situation by borrowing yen cheaply and investing it in currencies with a higher return. Frequently Asked Questions (FAQs) How do you profit from deflation? Deflation typically occurs during recessions, so the strategies for profiting from deflationary environments resemble other recession strategies. For example, fixed-income investments offer guaranteed streams of income, regardless of market behavior, as long as the issuer doesn't default. What happens to house prices during deflation? The prices for most assets decline during deflationary periods, including house prices. For example, from 1929 through 1933, house prices saw a median decline of 22%. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Bureau of Labor Statistics. “Consumer Price Index Database, All Urban Consumers,” Select “Top Picks,” Check “U.S. city average, All items,” Retrieve Data, Select “Range between 1929 and 1933,” Calculate percent change. World Trade Organization. “World Trade Report,” Figure B.2. Page 52. Federal Reserve Bank of New York. “Historical Changes of the Target Federal Funds and Discount Rates.” Columbia Business School. "The Battle Against Deflation: The Evolution of Monetary Policy and Japan's Experience." Standford University. "Causes of Japan's Economic Stagnation." Office of Investor Education and Advocacy. "Bonds." Bank for International Settlements. "The Costs of Deflations: A Historical Perspective," Page 38.