Deflation: Characteristics you should know before it impacts your portfolio

We talk a lot about inflation, but we rarely hear about its opposite: deflation. However, its characteristics can be just as relevant to your purchasing power. What really happens when prices fall instead of rise?

The main characteristics of deflation

Deflation describes a widespread decline in the prices of goods and services within an economy. At first glance, it seems positive: your money buys more things. But the characteristics of deflation go beyond that simplification.

The seemingly positive side: during these periods, the real value of your money strengthens, making products more affordable. Companies can also reduce their production costs thanks to cheaper materials. Furthermore, many people tend to save more when they see that their savings gain purchasing power.

The problematic side: persistent deflation discourages spending. If you know that prices will continue to drop, why buy today? This mentality reduces demand, slows down the economy, and increases unemployment as companies cut costs by laying off employees.

What causes the price drop

Understanding the characteristics of deflation involves knowing its origins. It generally emerges through three pathways:

Lower aggregate demand: when consumers and businesses spend less, overall demand falls, putting downward pressure on prices.

Excess supply: if companies produce more than what people want to buy—perhaps due to new technologies that lower production costs—the surplus drives prices down.

Strong currency: a robust currency lowers the cost of imports and raises the cost of exports, which also helps to reduce local prices.

Deflation vs. Inflation: Opposing Characteristics

Although both talk about price changes, their dynamics are radically different.

Inflation rises prices and erodes your purchasing power, incentivizing immediate spending. Deflation reduces them but discourages consumption. While inflation typically comes from higher demand or expansive monetary policy, deflation emerges from weak demand or more efficient technology.

The consequences also diverge: in inflation, people spend quickly before prices rise. In deflation, they postpone purchases expecting greater falls, creating a vicious circle of economic stagnation.

Strategies of central banks against deflation

Governments and central banks do not tolerate prolonged deflation well. Japan experienced this for decades, accumulating a low but persistent decline in prices.

To combat it, they resort to two main instruments:

Monetary policy: they lower interest rates to make borrowing cheaper, encouraging businesses and consumers to invest and spend. They can also implement quantitative easing (QE), injecting money into the economy to stimulate capital movement.

Fiscal policy: they increase public spending to boost demand, or apply tax cuts that leave more money available in people's pockets, encouraging them to consume and invest.

The balance of advantages and disadvantages

The characteristics of deflation present a mixed picture that cannot be ignored.

The favorable: cheaper goods improve the immediate standard of living. Savings gain real value. Companies operate with smaller but possibly more stable margins.

The problematic: less spending contracts the economy. Debt weighs more—if you borrowed money when prices were high, paying it back when they are low is more difficult. Unemployment rises when companies respond with mass layoffs.

Conclusion: understand to anticipate

The characteristics of deflation transcend the simple drop in prices. They represent complex economic dynamics that can improve certain situations while creating new problems. Recognizing these characteristics helps you better understand how governments respond, how your savings may behave, and why central banks prefer a controlled inflation around 2% annually as a balance point to keep the economy moving.