What You Should Know about Deflation for Trading

By Michael Griffis, Lita Epstein

In addition to watching the economic indicators for inflation, traders also need to watch the numbers for signs of deflation. Serious concern about the possibility of deflation takes center stage when prices start falling. Deflation occurs when a sustained period of falling prices takes place. The Great Depression of the 1930s was a classic period of deflation.

Many economists believe that printing more money cures deflation, because increases in the money supply normally lead to increases in prices when more money is around than goods to be purchased.

During periods of deflation, increasing the money supply isn’t necessarily the answer. Some economists believe injecting more money into the economy is risky, especially when production capacity is in excess and producers continue to produce goods even though prices are falling. Whereas, in other economic situations, producers commonly stop producing when prices fall.

In early 2004, Japan faced a continuing period of deflation even though its central bank had lowered rates to an effective negative interest rate and continued printing money in attempts to prop up its sagging pricing structure, and yet prices were continuing to drop. Some economists believe the Japanese experienced a liquidity trap. No matter how much money Japan printed, prices continued downward in a deflationary spiral.