Understanding deflation Featured

10:52am EDT March 28, 2003
Deflation, although uncommon since the Great Depression, normally occurs because there are too few customers chasing too many goods and services, resulting in competitive price-cutting that leads to layoffs, falling wages and a decline in business investment and consumer spending.

Consumers and businesses project that prices will be lower in the future, so they delay their purchases, making the economic climate worse and driving prices and wages down further. Households with decreasing wages and companies experiencing decreasing revenue and extensive debt are still forced to meet their fixed monthly expenses.

Often, bankruptcies result or spending is cut to meet obligations. This is what happened in the early 1930s, triggering the Great Depression.

For the past 12 years, Japan has faced and continues to experience deflationary pressures as prices fall. This type of deflation is characterized as "bad deflation."

On the other hand, price declines may occur when companies find ways to produce goods and services more cheaply. These productivity gains are passed on to consumers in the form of lower prices and on to workers as higher wages, as well as on to shareholders as higher profits. This mild deflation is considered "good deflation."

Some see a strong possibility of mild deflation developing in 2003, as the lackluster U.S. economy continues to face concerns over excess capacity, weak employment growth, high levels of consumer debt and deflation exported from the Pacific Rim countries. This combination of factors could lead to mild deflation in 2003.

Historically, however, mild deflation alone has not been a negative to either the stock or bond markets.

All deflation is perceived to be bad because it has been associated with past economic downturns. However, not all deflation occurs during economic weakness. Deflation may also occur during the early stages of an economic rebound, particularly when business confidence and inventory rebuilding advance ahead of consumer demand.

As the economy reverts back to equilibrium, deflationary pressures typically ease. Stock market performance tends to be better during nonrecession years when mild deflation exists.

Long-term interest rates are typically higher during high deflation periods due to weak economic conditions. Periods of deflation, whether mild or significant, usually tend to cause short-term interest rates to rise to levels somewhat higher than long-term average interest rates. Anthony S. Vargo is director of investment management for Legend Financial Advisors, Inc. Reach him at (412) 635-9210 or legend@legend-financial.com.