Why deflation is bad

Deflation occurs when asset and consumer prices fall over time. While this may seem like a great thing for shoppers, the actual cause of widespread deflation is a long-term drop in demand. 

Deflation often signals an impending recession. With a recession comes declining wages, job losses, and big hits to most investment portfolios. As a recession worsens, so does deflation. Businesses hawk ever-lower prices in desperate attempts to get consumers to buy their products and services. 

Deflation is measured by a decrease in the Consumer Price Index. But the CPI does not measure stock prices, an important economic indicator. For example, retirees use stocks to fund purchases. Businesses use them to fund growth. 

In other words, when the stock market drops, the CPI might be missing one important indicator of deflation as it's felt in people's pocketbooks. Comprehensive awareness of this economic indicator is important for effectively gauging whether or not a dramatic dip in the stock market will cause a recession. 

Neither does the CPI include sales prices of homes. Instead, it calculates the "monthly equivalent of owning a home," which it derives from rents. This is misleading since rental prices are likely to drop when there is a high vacancy. That's usually when interest rates are low and housing prices are rising. Conversely, when home prices are dropping due to high-interest rates, rents tend to increase. 

This is why asset inflation during the housing bubble of 2006 went essentially unnoticed. Had it been a focus, the Federal Reserve could have raised interest rates in an attempt to prevent the bubble. Such a strategic response might have also mitigated some of the pain when the bubble burst in 2007. Deflation slows economic growth. As prices fall, people put off purchases. They hope they can get a better deal later. You've probably experienced this yourself when thinking about getting a new cell phone, iPad, or TV. You might wait until next year to get this year's model for less. 

 balance.com