Deflation: Definition and What It Means for Investors

Americans have endured years of rising prices since the COVID-19 pandemic. And while prices likely aren't ever coming back down to 2010s levels, there are some indications that inflation is starting to cool.

In fact, on July 11, the Bureau of Labor Statistics (BLS) reported that the consumer price index (CPI) dropped 0.1% between May and June. That monthly decrease — the first since 2020 — marked a very brief dip into deflation.

It didn't last long; the July and August CPI reports showed small but positive monthly increases in prices. However, the June CPI report is a good reminder that consumer prices don't always go up every month.

So what is deflation, and what does it mean for the economy and financial markets?

Deflation definition

• Deflation is negative inflation; a decrease in prices.

• Disinflation is a decrease in the inflation rate; a slowing of price increases.

Disinflation is common, and natural, after a period of high inflation. The U.S. has been experiencing fairly consistent disinflation since the summer of 2022, when post-pandemic price increases peaked.

Deflation is rarer, and has historically been associated with recessions. The U.S. saw a few months of heavy deflation during the pandemic recession in 2020.

Is deflation a good or bad thing?

A decrease in prices throughout the economy might sound appealing — especially after the rapid increases we’ve been through recently. But economists say that sustained deflation might not be something to wish for.

According to the Federal Reserve Bank of St. Louis, long-term deflation may encourage people to delay purchases in the hopes of getting a lower price in the future. It also may encourage people to excessively hoard their money in savings accounts, as a negative inflation rate boosts the real (inflation-adjusted) yield that savers can earn.

Both of these forces can depress consumer spending, which can create recession-like conditions such as high unemployment and low corporate earnings.

However, the U.S. isn’t experiencing sustained deflation. We’ve only had one month of broadly-decreasing prices so far this year.

How might falling prices affect interest rates?

The bout of deflation back in July was unusual, given that we’re not in a recession, but it doesn’t mean the sky is falling. It might, however, mean that interest rates are falling in the near future.

The Federal Reserve has started to decrease the federal funds rate, after several years of increases that were intended to tamp down excessive inflation. But it has also indicated that it needs to see strong evidence of lower inflation before making further interest rate cuts.

Deflation — or even just sustained disinflation — could provide that evidence.

What kinds of investments could benefit from falling prices?

Certain kinds of stocks may benefit from falling prices — or more accurately, from an expectation of lower interest rates in the near future. For example, small-cap stocks, which often depend on borrowed money to stay afloat, are thought to be particularly sensitive to interest rate changes.

According to Roosevelt Bowman, an investment strategist with Bernstein Private Wealth Management, much of the market’s reaction to the brief incident of month-over-month deflation (and the September interest rate cut) may have already played out.

“Because markets have already anticipated it, that actual cut doesn’t mean a whole lot. I would argue that a lot of the gains are already in the market,” Bowman says.

How should investors respond to deflation?

Bowman says that for long-term investors, such as those saving for retirement in an IRA or 401(k), this kind of economic news doesn’t necessarily merit a change in your asset allocation, such as buying and selling certain kinds of stocks.

However, he says that there’s some value to paying attention to news about inflation and interest rates, for the sake of staying informed and knowing what to expect.

“Even as an investor with a long-term view, having some knowledge about what’s going on in the economy, and the general direction… I think that’s important for understanding your allocation, and also for managing your expectations about how it’s likely to perform over the short run,” Bowman says.