- Inflation measures the overall change in prices of goods and services over a set period—and deflation is the term used when these prices fall over time.
- Falling prices can have unfavorable effects on the economy, including rising unemployment and reduced demand.
- Central banks try to manage inflation, steering their economies away from deflation, through interest-rate policies.
Why are economists so concerned about deflation—the general fall in prices of goods and services? To understand why deflation can be considered an economic menace, one must first understand inflation.
Deflation is Nothing Without Inflation1
When inflation occurs, it means the average cost of goods and services is increasing. In the U.S., this is often measured by the Consumer Price Index and the Personal Consumption Expenditures Index. Both indexes take a representative pricing sample, or basket, of major categories such as food and beverages, housing, apparel, transportation, medical care, recreation, education, communication and energy. If, for example, the reference basket of items cost $100 last year, and inflation was measured at 2% over the past year, then that basket of items can be reasonably expected to cost $102 today. This does not mean the prices of all items in the basket will increase by 2%—some will rise by more, others will rise by less, and some may even fall.
While no one likes to spend more money than they have to, many economists believe a little inflation is a good thing for the economy. In fact, the Federal Reserve prefers to see inflation at roughly 2% per year. Most central banks similarly make low inflation a key policy objective. The thinking is that maintaining low inflation helps the market system avoid higher, unpredictable inflation—which is not conducive to investment or well-behaved currency exchange rates, and can cause turmoil in a country’s foreign trade.
The Price of Reduced Prices
While a central bank’s low-inflation objective can help protect an economy from unpredictable, sharply rising prices, it also helps protect against inflation rates falling below zero—or deflation. This is important for several reasons. One is that a falling cost of goods and services is often accompanied by a falling cost of labor (and thus lower incomes). In other words, while people may be spending less at the gas pump and the grocery store, their wages might drop as well. And as consumers are paid less, they become even less willing to spend as they wait for prices to fall even further. This results in further economic weakness and a deflationary downward spiral that can be difficult to reverse.
Perhaps the biggest concern about deflation among economists, however, is the effect it can have on debtors (borrowers) and the financial system. While creditors are hurt by unanticipated inflation, debtors are burned by deflation. If you borrow $100 and have to pay it back after a period of deflation, the $100—as well as the intervening interest payments—would have increased in value, thus making it more difficult for you to repay the loan. When this occurs across a market, and more and more loans start to go unpaid, the financial system itself experiences duress.
So deflation can cause a domino effect: stress on borrowers who have to pay back more in real terms than the nominal value they borrowed; which leads to stress in the financial system, as loans are not being repaid on time; which leads to tighter lending standards and bank failures; which leads to declines in asset values, a decline in overall demand (or collapse, if deflation is especially severe, as it was in Great Depression, along with widespread bank failures), rising unemployment, and underinvestment that imposes costs on future economic activity and output.
Managing Prices and Investor Anxiety
Investors concerned about inflation can include inflation-sensitive assets (such as commodities, commodity-related equities, credit, Treasury inflation-protected securities) in their portfolios that are designed to respond positively to inflation, as well as assets that are likely to hold up in the less-common case of deflation (cash, high-quality government and corporate bonds, and certain defensive equity sectors).
More from the Investment Fundamentals Series
There are risks involved with investing, including loss of principal. The Fund uses investment techniques with risks that are different from the risks ordinarily associated with fixed income and equity investments. Smaller companies and narrowly focused investments typically exhibit higher volatility. Investments in commodity-linked securities may be more volatile and less liquid than direct investments in the underlying commodities themselves. Commodity-related equity returns can also be affected by the issuer's financial structure or the performance of unrelated businesses. The primary risk of derivative instruments is that changes in the market value of securities held by the Fund and of the derivative instruments relating to those securities may not be proportionate. Derivatives and swaps are also subject to illiquidity and counterparty risk. Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile and be subject to greater levels of credit or default risk.
Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. For those SEI Funds which employ the ‘manager of managers’ structure, SEI Investments Management Corporation (SIMC) has ultimate responsibility for the investment performance of the Funds due to its responsibility to oversee the sub-advisers and recommend their hiring, termination and replacement. SIMC is the adviser to the SEI Funds, which are distributed by SEI Investments Distribution Co. (SIDCO). SIMC and SIDCO are wholly owned subsidiaries of SEI Investments Company.
To determine if the Funds are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses, which can be obtained by calling 1-800-DIAL-SEI. Read them carefully before investing.
Not FDIC Insured
No Bank Guarantee
May Lose Value