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, therefore; they delay their purchases making the
economic climate worse and driving prices and wages down further. Households (decreasing wages) and companies
(decreasing revenues) with extensive debt are still forced to meet their fixed
monthly expenses. Often, bankruptcies
result or spending is cut to meet their obligations. This is what happened in the early 1930’s triggering the Great
Depression. Japan has faced for the
past twelve years and continues to experience deflationary pressures as prices
are falling. The forecast for 2003 is
expected to be a decrease of approximately one percent per year. 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 onto consumers in the form of lower prices, onto workers as higher
wages as well as onto shareholders as higher profits. This mild deflation may be 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
being exported from the Pacific Rim countries.
The combination of these factors could lead to mild deflation in
2003. However, historically mild
deflation alone has not been a negative to either the stock or the bond
markets. The last time that the year
over year rate of change for the Consumer Price Index (CPI) ended down was in
If we face mild deflation (CPI flat to down 2.4%), have no
fear. The 24 years of mild deflation
since 1872 saw the stock market rise on average by 14.6%. When significant deflation occurred (CPI
down 2.5% or more) stocks performed poorly with average total returns of just
3.9%. Periods of significant deflation
are accompanied by a better “real return,” because the high deflation rate is
added to the stock’s performance.
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 occur during the early stages
of an economic rebound, particularly when business confidence and inventory
rebuilding advances ahead of consumer demand.
As the economy reverts to equilibrium, these deflationary pressures
typically ease. Stock market
performance tends to be better during non-recession years when mild deflation
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.
In summary, while serious deflation is always of concern to
everyone, historically, mild deflation will not necessarily prevent stocks from
rising. However, not all periods
achieve average returns either.
For further information, contact Louis P. Stanasolovich, CFP™ at
(412) 635-9210 or mailto:firstname.lastname@example.org.