There are fears that that the US economy could fall into a depression, and this could cause deflation. These concerns have emerged after US consumer prices fell 0.8% in April 2020. Most people understand that a depression is something that needs to be avoided, but what about deflation? It is less understood but is something that investors need to be concerned about.
Definition of deflation
Deflation is defined as the decrease of the general price level of goods and services. It is the opposite of inflation where there is a rise in general prices of goods and services.
Causes of deflation
Deflation may occur due to a decrease of demand for goods and services. This decrease on demand could be caused from a reduction of confidence in the economy. When this occurs, people are less likely to spend money and would rather save it.
Effects of deflation
- Deflation causes people to hoard money and put off spending it. When the general level of prices are falling, people will think about buying goods later believing they will be even cheaper. This causes company revenues to decrease so companies may need to reduce prices to offload their surplus of supply of products.
- Companies will see a decrease in demand and put off investment to expand the company which in turn causes the economy activity to slow.
- Deflation may cause redundancies or wage reduction as companies experience reduced revenue and look for ways to reduce fixed costs.
- The unemployment rate may rise during periods of deflation
- A rise in unemployment would cause the situation to worsen as household spending is reduced even further
- Interest rates may be reduced further as central banks try to stimulate the economy by increasing the money supply
- Deflation may make existing debts harder to pay off as debt payments stay the same but wages may decrease. This may mean that interest payments may take up a higher portion of an individual’s income.
- Businesses may also find it harder to service debt as their revenue may have decreased but debt repayment are unchanged.
- Bankruptcies can be on the rise if individuals cannot service their debts and are unemployed
- New borrowers will decline in a period of deflation so this will affect the profits of banking businesses
Lauren Hua is a private client adviser at Fairmont Equities.
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