Deflation: Definition, Types, Cause-effect, How to control

Deflation refers to the decrease in the general price level of goods and services in an economy over a period of time. Deflation is the process by which the value of money rises relative to commodities and services. This means the purchasing power of the currency rises. Deflation is categorized into demand-pull and cost-push deflation. Demand-pull deflation occurs when there is a decrease in aggregate demand in the economy.

As demand falls, businesses face unsold inventories and reduce production, which decreases overall spending and prices. Cost-push inflation arises due to a decline in the cost of production, which allows businesses to reduce their prices while maintaining profits. This leads to a fall in the general price level. Major causes of deflation include decreased consumption and investments, excessive debts, higher taxes, and increased productivity.

The effects of deflation are sometimes severe for the economy. Deflation decreases consumption and investments as consumers and businesses expect further price reductions in the future, which discourages spending. This decline in spending weakens the economy and potentially leads to an economic recession or depression. Deflation also raises the real value of outstanding debts, which becomes difficult for borrowers to repay. This makes the debt overhang problem even worse. To control deflation, central banks typically use expansionary monetary policy tools like lowering interest rates and quantitative easing to stimulate more investments and consumption in the economy. Fiscal policies like tax cuts also boost aggregate demand.

What is deflation?

Deflation is a prolonged period of overall downward pressure on prices in an economy. Deflation has a negative effect on company sales and profitability in stock markets. Consumers often postpone purchases during periods of deflation in the expectation that prices will drop more and they will eventually have greater purchasing power. They wait for sales and discounts rather than buying immediately.

This causes aggregate demand in the economy to weaken substantially. As demand falls, companies see their revenues shrink, which negatively impacts their top and bottom lines. Fewer sales mean lower revenues reported. With fixed costs remaining largely unchanged, profit margins compress significantly. Corporate earnings take a big hit during deflationary periods. 

A slump in earnings forces businesses to cut costs in order to maintain profitability. This often leads to layoffs and downsizing of workforces as companies try to slash expenses. Unemployment rises in the economy as more and more jobs are lost. Laid-off workers then have less money to spend, further reducing consumer demand and weakening the revenue environment for companies. The earnings declines that result put downward pressure on stock prices. Investors, worried about shrinking corporate profits, push share values lower.

Stock markets usually see a slump during deflationary times. Prices drop across various sectors as market-wide pessimism grows. Deflation also raises the real burden of debt on households, corporations, and governments. With falling prices, the same nominal amount of debt purchases more goods and services each year. But incomes typically don’t rise at the same pace, making debt repayments more onerous. The increasing debt loads strain personal and public finances.

What are the types of deflation?

The main types of deflation are money supply-side deflation, price deflation, growth deflation, bank credit deflation, credit deflation, and debt deflation.

1.Money supply-side deflation

This type of deflation occurs when the rate of growth of the money supply falls below the rate of growth of production in the economy. As a result, there is a smaller money supply chasing a larger volume of goods and services. This causes a decline in the general price level as there is not enough money available in the economy relative to output. Money supply-side deflation results from contractionary monetary policy actions taken by central banks to decrease the money supply, such as increasing interest rates or reducing the supply of bank reserves.

It leads to a shortage of money in the economy and puts downward pressure on both consumption and investment spending. Central banks use monetary policy tools such as open market operations, reserve requirements, and interest rate adjustments to influence the money supply in the economy. By restricting the availability of credit, they trigger a scenario where the money stock increases at a slower pace than growth in real GDP. This causes overall demand to drop as cash in circulation becomes inadequate to purchase all the goods on offer, resulting in money supply-side-driven deflation.

2. Price deflation

Price deflation occurs when the general level of prices for goods and services in an economy starts declining consistently over a period of time. This is usually measured as the annual decline in an economy’s Consumer Price Index (CPI). An economy’s average price level would completely decline when aggregate supply rises as a result of favorable economic conditions, increased manufacturing efficiency, decreased raw material prices, or technical advancements. In order to improve sales volumes, companies lower the prices if productivity grows noticeably and more quickly than demand.

Such a prolonged decline in the general price level across the board characterizes price-driven deflation. Price deflation becomes self-reinforcing once it begins. Lower prices increase consumers’ purchasing power, which they choose to hold on to rather than spend, reducing demand even further. Producers and retailers then cut prices further to try and boost demand. It erodes profit margins and corporate revenues, deter investment, and negatively impact both business and consumer confidence over the longer term.

3. Growth deflation

Growth deflation happens when an economy experiences a substantial rise in potential output relative to final demand. This occurs when the rate of economic growth exceeds the rate of growth of both consumer spending and aggregate demand. It arises from a surge in productivity, efficiency, or investment that enlarges the economy’s productive potential. However, businesses will have surplus capacity if consumer spending and general demand do not keep up. To utilize this capacity, producers and retailers consciously cut selling prices to increase sales volumes. Rapid increases in the supply of goods and services without a corresponding increase in demand cause growth-driven deflation.

Growth deflation is usually short-lived as lower prices will promote more purchases and help demand catch up with growing productive potential over time. However, during the initial period of divergence between high growth in supply and slower growth in demand, it does put downward pressure on the all-important cost-sensitive consumer prices. And that is what characterizes growth-driven episodes of temporary, mild deflation. Central banks also typically do not try to counter such deflation unless it persists for too long or intensifies substantially.

4. Bank credit deflation

Bank credit deflation arises due to a contraction in the money supply caused by a reduction in credit creation by commercial banks. A decrease in the money multiplier effect or bank lending cuts both leads to this. It occurs during periods of financial distress or crisis as banks become more risk-averse and tighten lending standards substantially. As credit growth slows or turns negative, the money supply comes under downward pressure, which is transmitted to the real economy.

A lack of available financing causes an automatic dampening of both consumer and business spending. Investment activity drops sharply along with reduced access to credit. This translates into a decline in the aggregate demand for goods and services. Producers respond by cutting prices to attract any remaining demand. Thus, a significant tightening of bank lending standards and reduction in the extended volume of credit potentially sets off deflationary dynamics through the bank credit channel.

5. Debt deflation

Debt deflation arises when a decline in the price level increases the real value of debt through the mechanism of leverage. During periods of falling aggregate prices, loans and mortgages that were taken out earlier at higher price levels remain fixed in nominal terms. With prices dropping, each unit of currency now services a higher number of dollars of debt. This reduces debt-servicing capacity and increases debt burdens relative to income levels. As debt loads rise in real significance and repayment ability weakens, households and businesses cut back on spending significantly to pay down loans.

Aggregate demand falls, putting downward pressure on prices in a self-reinforcing deflationary cycle. Over-indebtedness thus amplifies the broader deflationary impact. Debt deflation is most damaging during financial crises following a run-up in leverage, like the Great Depression era. It requires aggressive policy intervention to break the dynamic of higher real debt, triggering deeper spending cuts and even more deflation.

6. Credit deflation

Credit deflation describes a deflationary period caused by a contraction or restriction in the availability of new credit in the economy. It happens because lenders call in current credit lines, severely tighten lending rules, and reduce the amount of new loans made. The reduction in the flow of new money and purchasing power flowing from reduced credit origination acts as a drag on overall demand. As access to financing dries up, consumers and businesses are left with no choice but to save more and spend less.

Important spending categories like housing investment, durable goods purchases, and capital investments by firms, typically financed through borrowing, take a major hit. Overall consumption and economic activity slows in response to the deleveraging credit cycle. With demand declining, producers are pushed to cut prices, potentially sparking a self-reinforcing deflationary spiral driven by the credit channel. Central banks have fewer options to offset such privately driven deflation in credit markets.

How to measure deflation?

One of the most common ways to measure and calculate deflation is by using the Consumer Price Index (CPI). The CPI shows how much prices have changed for a basket of goods and services purchased by the average consumer. The Consumer Price Index (CPI) is used to measure changes in consumer prices experienced by the average household. It looks at a wide-ranging basket of goods and services that represent typical spending by consumers. This includes food, housing, transportation, medical care, and recreation. By tracking the price movements of these items over time, the CPI provides insight into inflationary or deflationary pressures in the economy.

The Bureau of Labor Statistics publishes CPI data on a monthly basis. It compares prices for the current month to prices from a fixed reference date in the past, usually a year earlier. Inflation is present if the index indicates that living expenses have increased since the reference period. On the other hand, deflation occurs when prices are lower. A percentage change is computed by taking the difference between the yearly CPI data and dividing it by the CPI of the reference period.

The formula to calculate the CPI is as stated below.

CPI = (Current Price Index / Base Period Price Index) x 100

For example, say the annual CPI for 2020 was 105, and the 2021 figure came in at 103. Subtracting the current year index of 103 from the previous year of 105 gives a difference of 2. Dividing this result by the base period CPI of 105 converts it to a rate of change. Multiplying by 100 expresses the change as a percentage. In this scenario, the calculation would be as stated below.

((105 – 103)/105) * 100 = 1.9% deflation rate

Monitoring changes in key components of the CPI also provides insights. Sustained drops across a wide range of goods signal broad-based weakness, warranting closer examination. Special attention should be paid to declines in more stable necessities like food, energy, and shelter, which account for a large portion of household spending. Significant price decreases in these areas point to deflation taking a firmer hold. In addition to government data, gauging inflation expectations through consumer and economist surveys offers early warning signs. Persistently lowered outlooks that spread beyond just a few months ahead often coincide with actual deflation taking root. Pessimistic views on future price dynamics impact spending and investment decisions currently. 

Monitoring the CPI on a monthly basis allows economists and investors to measure inflation or deflation trends over time using this standardized formula and a basket of goods approach. A sustained period of CPI readings below 100 demonstrates widespread deflation in the broader economy.

What are the causes of deflation?

The main causes of deflation are a decrease in spending and economic activity, which leads to falling demand, shrinking sales, profits, and revenues for companies that then reduce hiring, investment, and spending, exacerbating the downtrend.

1.Decreased consumer demand

One of the key triggers for initiating a phase of deflation is weakened consumer demand for goods and services in the economy. The total levels of consumption are negatively impacted when people cut back on their spending for a variety of reasons, such as increased unemployment, taxation, or living expenses. With lower consumer demand, companies are left with unsold inventory and are forced to cut prices to boost sales. This puts downward pressure on prices across the economy.

In the stock market, the falling consumer demand is reflected in weak corporate earnings growth. As people spend less, the revenues and profits of companies decline. The market reacts negatively to any indicators of lower consumer spending. Weaker demand sentiment makes investors skeptical about future profitability, putting downward pressure on stock prices and valuation.

2. Fall in production cost

A sustained decline in overall production costs across different industries potentially leads to deflation in the stock market as well. Organizations see a decline in production and operating expenditures when there is a sustained, large drop in the price of raw materials. With lower input costs, companies sometimes choose to retain some margin while also decreasing the selling price of products to boost volumes. This could create a wave of lower prices in the broader economy.

Simultaneously, falling costs improve the profitability ratios of companies from a long-term perspective. While current earnings sometimes do not gain substantially, stock prices face downward pressure if the market interprets lower costs as a sign of weaker aggregate demand. Lower margins will only become insignificant in relation to stock prices if demand continues to be strong.

3. Insufficient supply of money

One of the key factors that lead to a period of deflation in the stock market is an insufficient supply of money in the overall economy. Demand for products and services often declines across industries when people and businesses have less money to spend or invest. Lower demand usually results in declining prices as companies try to clear unsold inventory and sustain sales volumes.

In the stock market, this weakening of demand sentiment is reflected through a fall in corporate earnings as revenues stagnate or decline. As stock prices are significantly influenced by the present and expected future profits of the companies, a prolonged period of lower earnings drags the overall market into bearish territory. With less money available in the hands of investors due to various macroeconomic factors, stock prices sometimes continue correcting until inflation stabilizes.

4. Fierce competition in the market

Companies are fixated on stealing market share from competitors and growing swiftly when they are fiercely competing to outperform one another. This often means that they have to resort to discounting practices and slashing prices significantly to attract more customers. Additionally, with the emergence of new innovative firms, the existing major players also feel the pressure to reduce costs in order to remain competitive.

All of this price reduction behavior across different industries could come together to form an overall scenario of broad-based deflation in the economy. With companies focused more on gaining volumes by offering lower prices, their profitability comes under pressure. This would reflect negatively on stock valuations as well. Deflation has the potential to cause a downturn in the market if it persists for an extended period of time.

5. Adverse economic events

Adverse economic events could potentially lead to a scenario of deflation in the stock market. Unexpected macroeconomic problems, such as a worldwide recession, cause demand across industries to decline precipitously. Companies face declining revenues and margins as sales volume decreases significantly. In their attempts to cope with the downturn and minimize losses, firms resort to heavy discounting of prices. They engage in competitive price-cutting to attract customers and increase sales. Similarly, geopolitical conflicts like wars disrupt global supply chains and international trade.

They also cause commodity price volatility that increases input costs for businesses. As companies try to offset some of the inflationary cost pressures, they could engage in deflationary pricing strategies to boost demand and maintain margins. Such deflationary pricing activity across diverse sectors might collectively push down prices at the economic level if unfavorable economic conditions persist for an extended length of time. This could eventually be reflected in the stock market as well through lower corporate valuations and dampened investor sentiments.

6. Reduction in government spending

Expenditure reduction and fiscal austerity measures taken by governments to control large fiscal deficits exacerbate deflationary pressures in the economy. A decline in government spending reduces the aggregate demand directly since the government is also a significant spender on goods and services. With lower infrastructure spending, construction activities slow down. Even defense expenditures play an important role.

Reductions in government spending have an impact on the earnings and profits of different companies. A fall in government outlay towards various welfare schemes also impacts private consumption. All of this weakens the overall demand environment. Consequently, in the stock market, many companies face challenges in their business from government contracts. Declining earnings prospects due to lower spending pull stock prices down as well.

7. Rising interest rates

A steady rise in interest rates often indicates an economy moving from low inflation to deflation. Both individuals and companies pay more to borrow money when central banks hike interest rates. This discourages taking on new loans and investments. With financing becoming dearer, spending and investments drop in the economy. Lower consumption impacts corporate revenues and profits negatively.

Simultaneously, higher rates diminish the discounts applied on future cash flows when valuing companies. This makes stocks appear overvalued at current prices. Anticipating weakening earnings due to falling demand, investors begin pulling out money from equities. As a result, the rising borrowing costs drag down stock prices, triggering a phase of deflationary price adjustments in broader markets.

However, the overall economic stability fostered by gentle deflation supports higher equity valuations over time. Severe cases lead to depressed earnings and high uncertainty – conditions stocks despise.

What are the effects of deflation?

Deflation is sometimes disastrous for the stock market as falling prices lead to decreased consumer demand, lower corporate revenues and earnings, widespread job losses, shrunken wages, and a contracting economy, all of which feed on each other to drive stock valuations down.

1.Lower production

Lower production is a contributing factor causing deflation in the stock market. Businesses begin lowering their output of products and services when they observe a slowdown in demand brought on by customers deferring purchases. Factories scale back operations running at lower capacity utilization rates. Downsizing production helps control costs in the face of weakening sales, but it also removes potential supply from the economy.

As oversupply is corrected and inventory shedding takes place, wholesale prices begin declining. This then passes through the supply chain, showing up as lower consumer price inflation over time. As deflationary expectations build, people continue to wait for even lower prices rather than buying now. This causes demand and corporate revenue to plunge further, compelling firms to cut production even more. The resultant downward spiral in economic activity puts massive pressure on stock valuations already suffering from dampening earnings perspectives.

2. Lower wages

With falling demand for goods and services amidst deflation, companies are unable to pass on the brunt of rising costs to customers in the form of price hikes. To maintain profit margins, businesses resort to cutting wages, which is one of their highest expenses. As widespread layoffs affect workers across various sectors, many are forced to accept lower pay to keep their jobs. Shrinking household incomes weakens discretionary spending power.

With consumer demand slowing down the pace, companies receive fewer orders, and their cash flows get squeezed. To offset the loss of revenues, further cost optimization becomes necessary through additional wage reductions. Lower wages thus end up dragging inflation down while negatively impacting customers’ purchasing potential. The dampening of economic activity is reflected in corporate performance and outlook. Investor risk appetite takes a hit, contributing to stock market sell-offs on the back of deflationary forces at play in the form of declining remunerations.

3. Decreased demand

Decreased consumer demand is one of the primary drivers of deflation in stock markets. As prices start falling consistently over time due to an oversupply situation, customers find it optimal to delay purchases in hopes that items will cost even less in the future. This causes sales across industries to drop sharply. With lower outgoing volumes, companies have excess inventory on hand, which exerts further downward pressure on costs. In order to clear the piles of unsold stock and shore up liquidity, firms resort to price cuts and seasonal discounts.

Such competitive discounting only perpetuates the deflationary cycle. As demand weakens, corporate revenues take a major hit, forcing them to scale back operations, lay off workers, and stall capital investments. Reduced business spending then feeds back into weaker consumer spending. This negative feedback loop between falling prices, sales, and earnings cripples aggregate demand in the economy. The declines in top and bottom lines erode profitability and put stock valuations under significant downward pressure until inflation bottoms out.

4. Higher unemployment

As demand in the economy contracts due to falling aggregate prices during a period of deflation, companies are compelled to curb costs and survive on shrinking revenues. One of the first steps undertaken is reducing excess workforce through widespread layoffs. Higher unemployment claims are filed as more and more industries shed jobs. The unemployed not only lose their wages but also their purchasing power. With a dampening of discretionary spending among jobless individuals and households, demand takes a further hit.

As orders dry up, companies are forced to downsize operations even more, fueling a self-reinforcing cycle of rising job cuts. As the crisis spills over from one sector to another, unemployment climbs to alarming levels, weakening the economy. The stock market suffers enormously in this environment of pessimism, as lack of hiring dampens business prospects and future income potentials. Higher unemployment thus arises as both a symptom and aggravating cause of deflation plaguing corporate revenues and stock valuations.

5. Less consumer spending

Falling consumer spending is a major consequence as well as the driver of deflation in stock markets. As prices consistently decline, buyers tend to shelf their purchases in hopes of even lower costs down the line. This intentional delay in demand weakens retail sales across the board. With lower sales volumes, companies earn less revenue, forcing them to cut overheads like wages and jobs. Rising unemployment then shrinks households’ disposable incomes at their disposal for discretionary purchases.

Diminished consumption spending exerts additional downward pressure on prices as firms offer discounts to clear inventories. Continued price reductions further weigh on consumer confidence, compelling people to tighten their purse strings even more. The shortfall in aggregate demand slows overall business activity, crimping corporate profits. This feeds into pessimism surrounding future growth projections. Reduced spending thus exacerbates deflationary headwinds, accelerating the downward spiral in stock valuations reflecting battered earnings outlooks.

6. Lower profits

Lower profits form an important link in the causal chain of deflationary effects on the stock market. Revenues for businesses begin to drop dramatically as consumer spending wanes in a climate of lowering prices. In the face of weak demand yet high fixed costs, operating leverage kicks in to squeeze margins. To offset the profit hit, enterprises cut overheads by paring headcount or lowering wages. However, output also tends to drop as overall activity levels slim down. Fewer sales mean inventory pile-ups, which companies clear through heavy discounting, further weighing on margins.

Continuous price wars to steal market share only exacerbate price deflation. As margins compress severely under the double whammy of shrinking revenues and rising costs, corporate earnings rapidly deteriorate. Reduced profits reflect poorly on future growth potential and put intense pressure on equity valuations already reeling from pessimism. Weaker bottom lines thus emerge as both an effect and driver of the deflationary cycle, rattling stock markets through multiple rounds of sell-offs.

7. Less investment

Diminishing corporate investments contributes to the vicious circle of deflationary forces impacting stock market returns. Reduced pricing and demand lead to lower revenues and profits. Thus, businesses reduce capital expenditures to preserve cash flows. Postponing expansions amid uncertain economic conditions, businesses undertake only essential maintenance spending. Meanwhile, new projects and capacity additions are placed on the back burner. Reduced investments in new plants, equipment, and infrastructure weaken the productive capacity of the economy over time.

As the investment cycle slows, demand for machinery and equipment also tapers off, hurting associated industries. With lower capex, future earnings potential lack visibility, depressing equity valuations that are already under pressure. Less spending on growth further dampens aggregate demand, making it difficult for deflation to bottom out. This causes stock markets to remain in a downward spiral, completing the self-reinforcing nexus between low investments and falling corporate profits in a deflationary macroeconomic environment.

Deflation has severe adverse impacts across various segments of the economy. The continuous feedback loops between different effects reinforce deflationary pressures. Strong and coordinated monetary and fiscal stimulus is sometimes needed to prevent deflation from worsening into a full-scale economic crisis.

What’s the difference between good vs bad deflation?

The difference between good and bad deflation from a stock market perspective is that good deflation driven by productivity gains is positive for corporate profits and stock prices if real wages are still rising, whereas bad deflation caused by weak demand is highly problematic as it threatens earnings and debt burdens amid contracting economic activity.

For stock market investors, good deflation is positive. As productivity rises and costs fall, corporate profit margins expand, which fuels earnings growth and stock prices. Demand also remains strong since wage growth keeps pace with or exceeds price declines. Interest rates even fall modestly in real terms, providing a tailwind for valuation multiples. As long as real incomes are rising, good deflation need not inhibit consumption or aggregate demand. Bad deflation, on the other hand, happens if decreasing prices are brought on by dwindling demand as opposed to rising efficiency. This typically occurs during economic downturns when consumption and investment decline.

How to control deflation?

The central bank controls deflation in the stock market by keeping interest rates low and increasing the money supply. 

1.Quantitative easing

Central banks resort to quantitative easing measures during times of low inflation or deflation with the aim to stimulate economic growth and raise inflation. However, quantitative easing sometimes has the opposite effect and causes stock market deflation. A central bank stimulates the economy by injecting money through the acquisition of financial assets through quantitative easing. But this money does not directly increase consumption as it enters the banking system rather than consumers’ hands. The large amount of money in the hands of banks fails to spur demand as anticipated if banks do not lend it out aggressively.

With low lending, businesses are unable to borrow and expand. Low business spending reduces hiring and hampers payroll growth. This causes consumption to remain sluggish despite excess money in the system. The lack of demand growth sometimes causes inflation to drop lower or turn into deflation. Falling prices discourage consumers from spending as they expect items to be cheaper in the future. Businesses also cut back on investments and delay hiring in a deflationary environment of lower sales. With incomes and spending declining, corporate earnings take a hit.

Anticipating weak earnings growth, stock prices come under pressure, and markets start sliding into deflation. The huge sums pumped into the financial sector through quantitative easing flood the banking system with excess liquidity but fail to stimulate the real economy. This scenario results in a deflationary effect on stock markets rather than the intended reflation. The large money supply also raises concerns about asset bubbles as investors chase returns.

2. Cutting tax rates

While cutting tax rates aims to put more disposable income in the hands of individuals and businesses, it does not always lead to higher spending. Tax cuts lead to deflationary forces in the economy if they are not synchronized with monetary policy. Companies and consumers both benefit from lower tax rates, but they could be reluctant to spend the additional money if they are unsure about the direction of the economy. Individuals tend to save more of their pay rather than spend if the future looks unclear.

Similarly, businesses do not necessarily invest more or hire if demand is weak. The tax cuts also widen the federal budget deficit, requiring greater government borrowing. This pulls money out of the private sector and reduces overall spending. Lower spending impacts corporations as sales of their products and services do not rise as anticipated with the tax cuts. Profits come under pressure when revenue growth remains anemic despite tax breaks. Anticipating disappointing earnings, stock prices start declining. Further, a widening budget gap due to tax cuts creates higher debt levels for the government.

Rising public debt crowds out private investment to some degree and curtails broader economic growth. Higher government borrowing also means higher overall debt in the economy. Excess debt levels tend to deflate asset price bubbles over the long run. All these factors contribute to lower inflation or deflation in an economy, depressing stock market valuations. Coordinated fiscal and monetary stimulus is sometimes needed to offset any deflationary effects of tax reductions and ensure the cuts translate to an adequate demand boost.

3. Lowering interest rates

Central banks often lower interest rates in an attempt to stimulate borrowing and investment in the economy. However, lower rates do not have the desired effect and sometimes contribute to stock market deflation. Consumers and companies are encouraged to take out loans to purchase machines and residences when interest rates decline.

However, weak sentiment during uncertain times makes them reluctant to borrow even at lower costs. As a result, overall credit growth and spending remain sluggish despite accommodative monetary policy. Additionally, declining returns on savings also discourage spending as people try to rebuild investments, yielding lower returns. Companies see little reason to ramp up output, hire more workers, or invest in new projects. Profit growth struggles even though rates are lower. A fall in corporate earnings prospects pushes stock prices downward, feeding into deflation.

Investors have become concerned that lower rates will not be enough to revive growth and reignite inflation. They start pulling money out of risky assets like equities. Falling equity prices further dampen consumer and business mood, creating a negative feedback loop. Prolonged low rates also raise questions about central banks losing their ammunition if recession risks deepen. This boosts safe-haven buying of bonds, adding to downward pressure on yields and stock valuations. Thus, untimely rate cuts aimed at stoking recovery ends up having the opposite effect of stock market deflation.

4. Open market operations

Central banks conduct open market operations as a monetary policy tool to influence money supply and interest rates in the economy. However, large-scale bond purchases under open market operations during uncertain times depress stock prices. A central bank adds fresh capital to the banking system through the purchase of government or other assets on the open market. Banks might not lend out this additional money aggressively, though, if they are already well-stocked with extra liquidity and have a low-risk appetite.

As a result, the money supply expansion sometimes does not get transmitted effectively into the real economy in the form of credit and higher spending. Businesses are inclined to hold off on production and investments. Their earnings projections decline as sales volumes remain lackluster. Anticipating disappointing corporate performance, stock markets start correcting downward. Additionally, huge central bank balance sheet expansion through bond buying raises concerns about long-term inflation risks if and when growth revives.

It also crowds out private sector activity to an extent by soaking up investable securities. These factors tend to cause risk-off sentiment, hurting equity valuations. Sustained bond purchases also deflate yields and drive investors to sell off stocks in favor of bonds. Prolonged open market inflation that pushes excess liquidity into an economy without a rise in the velocity of money circulation feeds into stock market deflation dynamics.

5. Lowering bank reserve limits

Central banks mandate that banks maintain a percentage of their deposits as reserves to manage liquidity and mitigate risks. However, reducing these reserve requirements does not always have the intended expansionary impact and could contribute to stock market deflation. While lower reserve ratios aim to encourage banks to boost lending, they hesitate to do so aggressively if the overall economic environment remains uncertain and demand is weak.

Even though reserves have fallen, banks still need willing and creditworthy borrowers to lend the surplus funds to. Loan growth could not occur as anticipated with reserve reductions if businesses and consumers are hesitant to take on additional debt during a downturn. Spending and business investment do not accelerate either. Consequently, corporations do not see a strong reason to ramp up production and hiring. Their earnings projections stagnate, weighing on stock prices.

Moreover, investors view reserve cuts as an act of desperation by central banks during difficult periods. This damages confidence in the economic outlook and recovery. Waning sentiment sends investors to sell off risky assets like equities. Thus, untimely lowering of bank reserves aimed at increasing lending sometimes backfires if it coincides with sluggish demand. In the absence of a pickup in broader economic activity, such actions risk depressing stock valuations through weakened corporate fundamentals and erosion of risk-taking appetite.

6. Increasing spending by the government

During economic slowdowns, governments often try to stimulate activity by ramping up their own expenditures on infrastructure, welfare, etc. However, higher fiscal spending does not always have the desired effect and sometimes feeds stock market deflation. While increased government outlays are intended to spur demand, they come at the cost of widening fiscal deficits. Rising public debt levels pull funds away from the private sector that companies could have otherwise used for business expansion.

With higher government borrowing competing for funds, overall credit availability gets reduced. Furthermore, large deficits are difficult to sustain over the long run and raise concerns about higher taxes in the future. This discourages consumers as well as companies from major expenditures. Even public expenditure does not lift broader demand if citizens are uncertain about their incomes and employment prospects. In such a scenario, firms do not benefit from a demand revival and continue to witness sluggish revenues and profits.

Weak corporate performance drives down equity prices. Additionally, swelling government debt raises worries about macroeconomic stability if growth does not accelerate enough to pare the deficits. Such fears weaken investor risk appetite further, creating a self-fulfilling cycle of stock market deflation. Unless coordinated with complimentary demand-side policy tools, increased fiscal spending alone during periods of low growth sometimes has the perverse impact of depressing markets.

7. Purchasing governmental securities

Central banks regularly conduct open market operations to purchase government securities from banks and non-banking financial institutions. This is aimed at increasing the money supply and encouraging lending. However, large-scale buying of bonds is not always effective in boosting aggregate demand. During economic downturns, excess liquidity pumped in by central banks through such asset purchases does not always translate into more loans from financial institutions.

With weak growth, businesses report tepid demand and see little reason to borrow and expand. Even individuals remain cautious about taking on debt amidst dim job prospects and income outlook. The money meant to stimulate spending through bank and bond channels remains largely idle in the system. In the absence of a strong revival in core macroeconomic indicators, corporate profitability stagnates. Anticipating disappointing earnings, stock valuation comes under pressure.

Meanwhile, huge debt purchase programs swell central bank balance sheets exponentially and raise concerns about disruptions to price signals. Allocating more funds to bond markets also risks crowding out credit to productive sectors of the real economy. These macro-financial imbalances stemming from aggressive QE stoke deflationary pressures through erosion of business confidence and risk appetite for shares.

What are the tools RBI uses to control deflation?

The Reserve Bank of India uses monetary policy tools like lowering interest rates and increasing money supply to control deflation in the context of the stock market.

1. Repo Rate

The repo rate is one of the most important tools that RBI utilizes to control deflation in situations of stock market decline. The economy as a whole is frequently negatively impacted in a cascaded manner when the stock market experiences a dramatic and protracted decline. Stock market crashes discourage investments and dampen business confidence. It also curtails consumption as the wealth effect takes a hit. All of this eventually poses deflationary risks when aggregate demand slows down considerably.

In such times of economic slack, RBI acts swiftly by reducing the repo rate at which it lends short-term funds to commercial banks. A repo rate cut is transmitted to lower interest rates across the board and makes loans cheaper. This stimulates investments and boosts consumption to help counter deflationary forces in the economy arising due to stock market turbulence.

2. Reverse Repo Rate

A prolonged bear run in the stock market potentially leads to deflation as investors and businesses turn extremely risk-averse. Constantly declining share prices reduce wealth and reduce the desire to take risks. To infuse confidence and offset risk-off behavior during such times, RBI uses the reverse repo rate tool. A decline in reverse repo rate assures commercial banks of ample liquidity backup with RBI.

It encourages banks to maintain adequate liquidity in the system and continue lending operations instead of parking funds with RBI under the reverse repo window. By discouraging parking of excess funds, reverse repo rate cuts maintain interest rates at lower levels and incentivize businesses and consumers to borrow more. This helps boost investment and consumption activity to counter deflation cues emerging from heightened risk aversion during a falling stock market.

3. Bank Rate

The extended stock market could have an effect on bank lending practices since it strains the asset quality of borrowers. Businesses face viability issues as their collateral in the form of publicly traded shares declines sharply in value. This leads to higher risks for banks in their corporate loan book. As a result, banks tend to turn more cautious and tighten credit standards, which exacerbates the economic slowdown.

In such a situation, RBI uses the bank rate tool to signal its accommodation and ensure the transmission of easier monetary policy. A cut in bank rates emphasizes RBI’s commitment to maintaining adequate liquidity in the system at lower interest rates. This encourages banks to continue lending operations on preferred terms rather than raise rates. By limiting tight credit scenarios, bank rate adjustments support the flow of credit to productive sectors and counter deflation risks emerging from prolonged stock market corrections.

4. Open Market Operations

Risk aversion among investors and businesses results from a protracted bear market in stocks. The decline in equity wealth diminishes cash flows and discourages corporations’ investment plans. This poses a threat of an economic slowdown. To boost sentiment and provide liquidity support in such a situation, RBI makes active use of open market operations. Through regular OMO purchases of government securities from banks, RBI infuses substantial cash into the banking system.

The additional liquidity encourages lending and lowers interest rates in the broader market. As funds flow more easily, they support the investment and consumption needs of businesses and consumers. The objective is to increase aggregate demand and offset pessimism arising from extended stock market corrections. By proactively using OMOs, RBI aims to ensure financial conditions remain easy and accommodate growth despite weak deflationary undercurrents from fallen equity prices.

5. Statutory Liquidity Ratio (SLR)

A sustained downturn in the stock market triggers a liquidity crunch if bankers become excessively risk-averse and prefer parking funds in safe government bonds. A persistent decline in share prices reduces the universe of companies that banks are able to invest in, as funding constraints put pressure on companies and repayment capacity erodes. As a precaution, banks tend to raise their holdings of liquid and risk-free SLR securities like treasury bills, which strains overall credit availability.

To alleviate such liquidity tightness during bear markets, RBI uses the SLR tool. It temporarily reduces the SLR requirement, allowing banks to substitute some of these holdings with more loans. This frees up resources for banks to continue lending. By ensuring adequate credit flow even during periods of risk-off in stocks, SLR adjustments help RBI control deflation risks of a deteriorating investment scenario caused by a protracted stock market correction.

6. Cash Reserve Ratio (CRR)

A drawn-out downturn in the stock market erodes business confidence and discourages capital investments. As companies become wary of utilizing their internal accruals, financing activity decreases at a time when the economy needs greater impulse. To boost liquidity and stimulate bank lending under such conditions, RBI deploys CRR reductions. By lowering the share of deposits that banks must maintain as reserves with RBI, more resources are made available for fresh lending.

A decline in CRR swapped out reserves with credit, keeping larger funds in circulation within the banking system. This allows easier credit flow even as risk profiles deteriorate amidst extended market pessimism. Increased bank lending helps offset plant shutdowns and canceled projects that arise from subdued corporate spending due to uncertainty in a falling stock market. It assists RBI in containing deflation stemming from reduced investment demand caused by protracted bear market cycles.

7. Liquidity Adjustment Facility (LAF)

Businesses typically reduce their ambitions for expansion and become cautious when it comes to recruiting or increasing capacity when stock markets see a prolonged slump. This poses the threat of rising unemployment and falling income levels in an economy. To maintain adequate liquidity to support growth, RBI relies on LAF operations by providing funds to banks through repo auctions and absorbing excess liquidity through reverse repo. A consistent surplus of liquidity during bear markets is vital.

It ensures interest rates remain aligned to policy signals. Easy financial conditions encourage banks to keep lending at lower rates even as risk profiles rise amid falling equity prices. The ready availability of funds at the LAF repo window maintains resources within the banking system to keep credit flowing for jobs and consumption. This helps control deflation in an economy from materializing due to reduced investments and spending during a prolonged equities market correction.

8. Market Stabilisation Scheme (MSS)

Financial markets become more volatile when stock markets undergo steep and protracted falls. Sustained risk-off sentiment sometimes triggers unstable market dynamics like self-reinforcing sell-offs. In such scenarios of elevated uncertainty, RBI makes use of the Market Stabilisation Scheme balances to inject market confidence. Under MSS, RBI chooses to buy or sell government-dated securities directly using the securities held under this fund.

Strategic open market operations from MSS reassure market participants of policy support even during periods of equity sell-offs and stabilize government bond prices. Stable financial conditions encourage orderly market functioning instead of disorderly movements driven purely by sentiment changes during a bear market phase. This helps limit any contagion or spillovers to the real economy that potentially amplifies deflation due to a loss of wealth and squeeze on liquidity accompanying an extended slump in stock prices.

A prudent combination of conventional and unconventional measures prevents panic but also ensures adequate policy stimulus is provided depending on the severity of price pressures. With prudence implementation, these tools help RBI achieve its mandate of maintaining price stability conducive to sustainable economic growth over the medium term.

What are some historical examples of deflation?

Four historical instances of deflation are provided below.

European countries struggled with deflation from 2011 to 2015 during the European debt crisis. Countries like Greece, Spain, Italy, and others in the European Union saw negative annual inflation rates during this period as the crisis battered their economies. Greece, in particular, experienced deflation for three years from 2013 to 2015, with prices falling by 1.1% year-over-year. 

Hong Kong faced a prolonged bout of deflation following the Asian Financial Crisis in late 1997. Inflation rates remained below zero until the fourth quarter of 2004 as the Hong Kong dollar was pegged to the strong US dollar, forcing deflationary adjustments. With imports becoming increasingly cheaper from mainland China as well, weak consumer confidence exacerbated the price declines.

Ireland entered into deflation in early 2009 during the Global Financial Crisis, recording its first period of falling prices since 1960. In January 2009 alone, prices fell 0.1% compared to the same month in 2008. The country’s annual inflation rate was recorded at -1.7% that year. Deflation also posed challenges for policymakers as they considered budget cuts to combat high fiscal deficits.

Japan has grappled with intermittent deflation for decades since asset prices crashed in the early 1990s. Despite aggressive monetary easing by the Bank of Japan, including cutting rates to near-zero, prices continued falling by over 1% some years. Only in 2014 did new policies under Prime Minister Shinzo Abe help bring multi-year high inflation. But more recently, the country dipped into deflation again in 2020 during the Covid-19 pandemic.

What is the difference between deflation vs inflation?

The main difference between deflation and inflation in the stock market context is that deflation leads to falling stock prices as money becomes more valuable, while inflation leads to rising stock prices as money loses value.

In times of inflation, the overall level of prices for consumer goods and services tends to rise continuously over a period. We typically measure this by looking at changes in a price index such as the Consumer Price Index. Each unit of cash is able to buy fewer products and services than it might in the absence of inflation. As prices rise, the real value of money goes down. Within the stock market, periods of inflation have tended to favor sectors such as energy and materials, which pass on higher costs to consumers.

Companies producing daily essentials also perform well as consumers continue spending. However, very high and unpredictable inflation levels introduce economic uncertainty, which is negative for business investment and stock valuations. Deflation has the opposite effect, as the general price level in the economy falls over time rather than increases. Each unit of currency buys more under deflationary conditions. For businesses and individuals, the real value of outstanding debts increases, which squeezes profits and purchasing power.

Within asset markets like stocks, deflation leads to a difficult economic environment. As product prices fall continuously, corporate revenues drop while the need to service existing debt obligations remains. This erodes company earnings, and the outlook for profit growth detracts from stock prices. Historically, deflationary periods have often led to stock market crashes as investors lose confidence and rush to raise cash.

Is deflation more harmful than inflation?

Yes. While inflation and deflation both pose economic risks, deflation tends to be more harmful to an economy. Deflation is a condition in which prices decline gradually over time, which could seriously damage investment and consumption. Individuals and businesses are incentivized to delay spending in hopes that prices will fall further, reducing consumption. At the same time, investment also declines as companies see little reason to invest in expanded capacity or new capital projects if demand is falling. This downward spiral of reduced consumption and investment is very difficult for an economy to escape from once entrenched.

What is the difference between deflation vs. disinflation?

The difference between deflation and disinflation in the stock market context is that deflation leads to a sustained decrease in prices and continuously falling stock prices, while disinflation is a slowing of price increases leading to moderating stock price gains. Deflation is the gradual decline in the average level of prices in an economy for goods and services.

This destabilizing occurrence actively undermines consumption and investment activities. As prices decline, consumers feel wealthier on paper and delay purchases in anticipation of items becoming even cheaper down the road. Producers meanwhile see reduced demand and sales, hesitant to stock inventory that declines in value. The falling prices spread through the economy as businesses reduce output and employment to cut costs. This vicious cycle rapidly contracts broader economic activity.

The inception of disinflation commonly stems from an economic slowdown, reducing consumer expenditures and putting downward pressure on costs. However, disinflation need not have disastrous effects if it is just ephemeral. A pullback restoring prior inflation levels could revive spending and circulate demand once more through the marketplace. However, determining whether disinflation proves transient or indicative of deeper structural weaknesses tests the foresight of market analysts. Prolonged disinflation threatens to morph into full-fledged deflation by shaping business and household confidence the longer prices rise sluggishly. 

Several factors differentiate short-term, transitional disinflation from its riskier, protracted form. Temporary disinflation often correlates to external shocks disrupting typical supply and demand alignments, such as temporary commodity price declines or weather events impacting crop yields. These exogenous forces dissipate over time without broader impacts. Yet signs like stagnant wages despite low unemployment, excess industrial capacity indicative of poor sales prospects long-term, and flagging productivity growth across industries all point to entrenched disinflation unlikely to self-correct without policy intervention. Such embedded slow inflation portends deflation sometimes looms on the not-too-distant horizon should recession strike.

For stock investors, the kind of disinflation transiently dampening inflation rates proves generally less concerning than its chronic version, foreshadowing steeper declines ahead should economic weakness transform into contraction. Temporary disinflation still occurs within an expansive context supporting profits and growth, if at a somewhat slower pace than prior periods. However, durable disinflation embedded within structural issues cautions corporate fundamentals sometimes deteriorate more markedly in a potential downturn. Equities typically reflect accelerating risks of deflation, translating disinflation into a prelude of trouble rather than an isolated speed bump delaying inflation. More abrupt changes in share prices are frequently associated with prolonged deflation, which exposes underlying weaknesses that deflation sometimes possibly worsens.

What is the difference between deflation vs stagflation?

The difference between deflation and stagflation in the stock market context is that deflation leads to falling stock prices as money becomes more valuable, while stagflation leads to stagnant or falling stock prices despite rising inflation due to poor economic growth. A broad fall in all price levels across the economy is referred to as deflation. As the cost of goods and services drop in a staggered fashion over successive periods, consumption typically weakens in anticipation of even lower future prices. Producers correspondingly reduce output and headcounts to cut expenses, further depressing demand. A self-reinforcing deflationary cycle thus emerges when widespread price decreases undermine spending and investment activity. 

In market terms, deflation substantially diminishes corporate revenues and constricts profit margins. Faced with deteriorating fundamentals, equity valuations reflect lowered expected returns going forward. Additionally, deflation promotes holding cash due to its maintaining or growing purchasing power over time. This sentiment weighs on economic functions reliant on active money circulation. As the deflationary vortex gains momentum, stock prices succumb to the contracting activity and bearish psychology drawn from the experience of falling asset values across sectors.

In contrast, stagflation denotes high inflation occurring alongside a stalled economy. Rather than reflecting weak demand across industries, cost increases pervade much as output capacity lies underutilized. This combination stems from supply-side constraints limiting production potential despite robust consumer demand. Common stagflationary causes include short-term supply disruptions from adverse weather or geopolitical crises restricting commodity flows globally. Additionally, rising input costs like energy filters throughout an economy lift prices at a time of general slack. 

What is a deflationary spiral?

A deflationary spiral occurs when a fall in prices triggers a negative feedback loop that causes prices to fall even further. This happens in the stock market when declining share prices lead to worsening economic conditions, which then drive prices down even more. Investors will witness a decline in the value of their portfolios if the stock market begins to decline considerably.

This dent in wealth causes people to curb their spending as uncertainty about the future increases. With less demand for goods and services, companies earn lower revenues and profits. In order to cut costs, they start laying off workers or reducing wages. This drop in income hits the broader economy hard. As people earn less money, they spend less at shops, restaurants, and on other discretionary items. Aggregate demand falls as consumers tighten their belts. With lower revenues already, the shrinking consumer spending exacerbates companies’ problems. Many will see no choice but to cut costs even more deeply through further job cuts or bans on hiring.

Now, with large numbers of people unemployed or underemployed, not only do their personal incomes decline, but so does their confidence. Worried about their job security and financial futures, the newly jobless or lower-paid consumers drastically reduce their discretionary spending. Their pullback in spending adds downward pressure on the overall economy. At the same time, businesses seeing contracted demand and shrinking profits decide to halt or reverse their investment plans. Fewer new capital expenditures mean lower productive capacity and a worse business environment in the long term.

The drop in business investment is another major drag on broader GDP growth. This deteriorating economic picture starts negatively impacting corporate earnings. With less revenue coming in the door and higher costs from job cuts, companies report lackluster quarterly profits or losses. Their sinking financial results change market expectations of future cash flows and returns. The original stock price declines look more serious and prolonged.

Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.