When deflation arrives: Why market reactions are often misaligned

The Economic Phenomenon Most People Misunderstand

Deflation sounds good—prices of goods fall, money becomes more valuable, consumers spend less to buy more. But the market’s real reaction is often the opposite. Let’s look at the logic behind this economic phenomenon and why it can become an invisible killer of the economy.

How Exactly Does Deflation Form?

Price drops caused by demand gaps

What happens when overall societal spending suddenly plummets? Consumers and businesses both tighten their belts, and total market demand shrinks. Facing unsellable inventories, manufacturers have no choice but to keep lowering prices. This is not a good sign—it’s a signal that economic vitality is waning.

Excess capacity pressure

Technological progress is usually praised, but problems arise when all companies significantly increase capacity using new technology. Market supply far exceeds demand, production costs fall, and prices naturally drop. On the surface, it’s “cheaper,” but in reality, it’s “unsellable.”

The invisible impact of a strong currency

A country’s currency appreciation may seem impressive, but at what cost? Imported goods become cheaper, while domestic companies’ products become more expensive on the international market. Export demand declines, and domestic prices follow suit. This form of deflation is passive, often accompanied by trade imbalances.

Deflation vs. Inflation: Both Can Damage the Economy

Opposing concepts on the surface

Inflation is rising prices, deflation is falling prices. It sounds opposite, but they cause entirely different types of damage to the economy.

Nature of price movements: Deflation increases the purchasing power of money but also makes debts relatively heavier; inflation weakens money’s purchasing power but encourages people to spend quickly.

Underlying economic drivers: Deflation stems from demand contraction, excess capacity, or technological shocks; inflation results from excessive demand, rising production costs, or central bank easing policies.

Fundamental differences in economic experience

In a deflationary environment, rational consumers wait. Why buy today if it will be cheaper tomorrow? Once this mindset takes hold, societal consumption drops sharply. Businesses facing demand exhaustion start layoffs and cost-cutting. Unemployment rises, further shrinking consumption—this is a death spiral.

In contrast, during inflation—people fear money devaluation and rush to spend or invest. This pushes demand up, companies expand production, and the economy appears very “active.”

The Double-Edged Truth of Deflation

The seemingly positive side

Money becomes more valuable: The same 100 yuan can buy more next month than now.

Business costs decrease: Raw materials and labor costs fall, theoretically increasing profit margins.

Savings become attractive: Money in accounts appreciates in value (relative purchasing power), giving savers psychological satisfaction.

The harsh realities

Consumption freezes: Do people really stop spending? Yes. Since things are getting cheaper, why buy now? This causes retail sales to plummet.

Debt black hole: Borrowers with 1 million debt are in trouble. Prices fall by 50%, but the nominal debt remains unchanged. In reality, they owe more. Bank non-performing loans increase, and financial system vulnerabilities rise.

Unemployment crisis: Business income declines, and they can’t stimulate sales by lowering prices (since customers are just waiting for discounts). The only option is to shrink operations and lay off workers. Rising unemployment fuels social tensions.

Central Bank and Government Countermeasures

The arsenal of the central bank

Lower interest rates: Reduce borrowing costs to encourage businesses and consumers to start spending again. But in deep deflation, low rates have limited effect—if people believe prices will keep falling, even lower interest rates can’t change their waiting mindset.

Quantitative easing: The central bank injects liquidity directly into the market, increasing money supply in hopes of stimulating spending and investment. This is psychologically important—showing the central bank’s firm stance.

Government fiscal tools

Increase spending: Directly pump money into the economy—through infrastructure investments, government salaries, social welfare. This can immediately generate demand and break the consumption freeze.

Tax cuts: Leave more cash with consumers and businesses, encouraging them to spend or invest. This is an indirect stimulus, slower to take effect but more sustainable.

The Deflation Spiral: Lessons from Japan

From the 1990s to the 2010s, Japan fell into a long-term low-inflation or deflationary trap. After the real estate bubble burst, demand collapsed. Businesses and consumers both stopped spending, and prices kept falling.

Japan’s central bank and government tried all measures—interest rates near zero, quantitative easing, large-scale government investments—but economic growth remained weak. This proves one point: once deflationary expectations take hold, policy alone is hard to reverse.

Summary: Why Is Deflation So Dangerous?

In the short term, deflation indeed makes goods cheaper and money more valuable. But in a prolonged deflation, the economy can fall into a vicious cycle of consumption freezing, debt deterioration, and rising unemployment. While central bank and government policies are effective, truly defeating long-term deflation requires a complete shift in psychological expectations—often taking time and being triggered by shocks.

For investors, the real danger isn’t deflation itself, but the economic recession signals it reflects and the systemic decline in asset prices.