After persistent inflation since 2021, falling prices in the U.S. are causing some to worry that the opposite will occur: Deflation, or declining prices.
“The Fed’s extreme policy actions of the COVID and post-COVID period are raising concerns over both inflation and eventually deflation,” says Steven Wieting, chief investment strategist at Citi Global Wealth. “The U.S. is now experiencing the first decline in broad money supply since the late 1940s.”
Checking and savings account deposits declined by more than 3.5% in the past year. Such declines can lead to widespread price decreases and even a depression.
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Deflation can be devastating to an economy, but true monetary deflation is rare, Wieting says. That said, it behooves investors to know what lays ahead and how to prepare themselves and their portfolios for whatever may come.
What causes deflation?”Not to sound like an Economics 101 textbook, but it all comes down to supply and demand,” says Mike Reynolds, vice president of Investment Strategy at Glenmede. In the short term, deflation can be caused when there is less demand than supply for goods, forcing producers to drop prices in an effort to entice buyers to purchase their products.
Over the longer term, deflation is usually caused by tight monetary policy when the Federal Reserve raises interest rates. This causes consumers to prioritize saving and investing over spending, leading to lower demand and thus price declines.
The last instance of prolonged deflation in the U.S. was the 1930s. “Former Fed Chairman Ben Bernanke rather famously noted the Fed’s responsibility for this,” Wieting says. “It was a period of high real interest rates and contracting money supply, recognized far too late.”
Is deflation bad for the economy? “The short answer is it depends,” Reynolds says. “There’s a difference between transitory and persistent deflation.”
Transitory deflation, when prices drop temporarily and people believe the decline will be short-lived, usually doesn’t cause too many problems for the economy, he says.
Similarly, localized deflation when a good whose prices rose due to extraneous circumstances, such as when an avian flu outbreak drove up egg prices, and then renormalize are not uncommon.
Other examples of transitory deflation that may not be harmful to the economy include a jump in supply that is not met by immediate demand, which can actually be stimulative for future growth, Wieting says.
“An example would be a new technique or major discovery of oil,” he says. “Sometimes import prices drop because of demand weakness outside the U.S. economy.”
Technological advances can also cause deflation. “When there are leaps in technology to produce more, a very favorable deflationary dynamic can boost the economy,” Wieting says.
Deflation becomes a problem when it is persistent and pervasive. When deflation occurs across multiple goods and services – which is a rare occurrence in advanced economies – it can be dangerous to economic health.
“If deflation persists for a long period of time and becomes a normal part of how people think about prices, it can be risky for the economy,” Reynolds says. “If consumers come to believe that the prices of goods are going to be cheaper tomorrow, they can become incentivized to put off spending until then.”
This can cause real economic activity to contract and potentially lead as far as a depression, he says.
Is deflation more harmful than inflation?”On the surface, it might seem that deflation is preferred to inflation,” Reynolds says. “After all, who would say cheaper prices aren’t better?”
However, deflation can be a symptom of a structural imbalance in the economy. Reynolds points to Japan as an example. The country’s demographic and corporate governance issues have “driven its economy to operate below its potential for decades,” he says. “This has been a big factor behind Japan’s constant struggle to generate meaningful economic growth over the past decade.”
Sustained deflation can lead to depressions, as the U.S. experienced in the 1930s.
Deflation can also be hard on borrowers, who struggle to repay fixed-rate debts as their incomes decline and may therefore avoid taking on more debt. “This is especially true for companies, which often take on debt to finance new projects that can enhance productivity and boost economic growth – that unwillingness to borrow can make an impact,” Reynolds says.
That said, neither runaway inflation or deflation are particularly desirable.
How does deflation affect investors?Deflation is not a stock investor’s friend. Falling prices “shrivel” corporate profits, Wieting says. And when corporate profits fall, stock prices follow.
“Persistent deflation is a headwind to economic growth, which is a key driver of fundamental results for companies,” Reynolds says. “In addition, many types of companies may lose pricing power as costs remain sticky, which then puts pressure on profit margins.”
Such scenarios often make lower risk assets like Treasury securities more favorable because they pay regular income and this, like cash, will at least be able to hold its purchasing power as prices decline.
“A lasting deflation would boost only the very safest assets, such as U.S. government bonds,” Wieting says.
Is the U.S. heading for deflation?To accurately address where the U.S. economy sits currently, it’s important to distinguish between deflation and disinflation. Deflation is negative inflation, which occurs when prices fall. The U.S. is seeing deflation in certain products, such as eggs, the price of which declined by 7.9% between June 2022 and June 2023, and gasoline, the price of which declined by 26.5% in that same period.
Wieting says it is unlikely the U.S. will experience persistent deflation. “We do believe the U.S. is experiencing a faster drop in underlying inflation than many expect,” he says. “Ultimately, the Fed will be too restrictive for the period ahead, but we see no reason for the Fed to keep tightening monetary policy if inflation and employment weaken together.”
Disinflation refers to slower inflation. The U.S. has been experiencing disinflation for 12 consecutive months based on the headline Consumer Price Index (CPI) as of June 2023.
“The most important question will be at what run-rate inflation ultimately settles out,” Reynolds says. “There remains a risk that the last leg of returning inflation to the Federal Reserve’s 2% target could be the most difficult.”
The extra effort required to achieve this is likely to cause a recession, Reynolds says. “Equity market valuations do not appear to be properly reflecting this heightened recession risk, warranting a defensive portfolio posture.” Glenmede recommends investors underweight equities in favor of fixed income and cash in anticipation of this likely recession.
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