In fact, the defacto textbook for investing ("Investments" by Bodie, Kane, and Marcus) has 12 different index entries related to inflation. How many entries does it contain for deflation? ZERO!
If you took the headline to heart, your probably thinking it's great! I mean, when is getting more for less a bad thing?
In fact, you've probably even tried to become a source of deflation, and you don't even know it. Ever haggle with a store clerk? Ever look to buy a home and point out all its flaws before making an offer? In both cases, you are trying to deflate the price, so you can get more with less.
If your low-ball offer is accepted, then congratulations! You've just caused a momentary period of deflation. As great as that sounds, it is not always the best thing since sliced bread.
Here are a few more examples of when deflation of 3% could be good, managed, and bad.
3% deflation is good when...
3% deflation is manageable when...
3% deflation is bad when...
Using these simple examples gives you a powerful rule of thumb:
Deflation is good when you're looking to buy and bad after you've bought.
In order to stay profitable, companies cut costs. At first, they'll try to lower production volumes, which means they will make less product to sell. When production is lower, fewer employees are needed to oversee the operations and lay-offs follow.
Some experts argue that falling prices also mean falling costs, because businesses can buy raw materials at a lower price, and those cost savings to the company on the input side can offset the lower selling prices on the output side. Everyone wins.
Unfortunately, there's a small problem with this logic. Labor costs (i.e. our paychecks) do not fall in a deflationary environment.
Have you ever heard of a "negative" cost of living raise? Or how about a cost of living "cut" instead of a raise? If prices are lower, then it shouldn't be a big deal because we can still buy the same amount of stuff, right? Right.
The reality is that adjusting wages downward is seen as a pay cut, regardless of what prices are doing. That's why you don't hear about them until companies only other option is layoffs. In fact, layoffs are the most common corporate strategy during deflationary periods.
And when workers are laid off, they spend less money. In order to try and motivate people to buy things, companies continue to lower prices, which leads to lower profits.
People with money have no motivation to spend it, because money becomes more valuable over time(i.e. you can buy more with $1 tomorrow than you can today).
When there is too much supply and not enough demand, companies lower prices in an attempt to get people to buy more stuff. Who doesn't want to by something when it's "on sale"...think year closeouts or liquidation sales.
What causes too much supply and not enough demand? Lack of spending. But what causes a lack of spending in the first place...and at a big enough level to impact a nation's economy?
It all begins with something called "credit tightening". When debt is cheap, it is considered to be "loose"; there isn't much risk, and it's pretty easy to get a loan. As rates increase, it becomes harder to get a loan (i.e. credit tightening).
Now you may be asking what causes credit tightening? There are three broad things that can cause tightening: rising interest rates, economic shocks, and price competition.
You can see credit tightening in action when you're thinking about getting a new car using a loan from the bank. A higher interest rate means that your monthly payment is also higher. This means there is less money left over for other things you may want to purchase during the month. You may opt to wait for a lower interest rate, and either save your money or spend it on something else. Companies are no different.
If banks were to fail, then so would the U.S. economy. It's this thought process that led to the term "too big to fail" during the credit crisis of the late 2000's. Widespread banking failures would have put the U.S. into a deflationary spiral, causing massive unemployment.
When the economy is doing well, inflation can become too high. The Federal Reserve raises the federal funds lending rate, which raises the interest rate on debt.
The thought is that this action will decrease the rate of inflation and/or even cause a little deflation ("little" being the key word there).
All this leads to lower production of goods and services and less hiring, which slows economic growth.
When fighting inflation, central banks can raise rates as high as needed to get things under control. There will be consequences, but at least inflation can be managed. If strong action is NOT taken, or the underlying issues are too great, hyperinflation can occur (essentially uncontrollable inflation).
When fighting deflation, central banks can lower interest rates, with the intent of increasing debt spending and spurring inflation.
However, the fed can only drop rates so far. And as rates approach zero, they become less and less effective. Negative interest rates were once thought to be an impossibility. But as of the 2010's, we know that they are indeed possible. The issue is the follow-on impact; since they were largely theoretical, we don't really know how real world systems will react. What we do know, from those theories, is that the results usually aren't positive (demand destruction, job losses, etc.)!