The standard definition of “deflation” is “a fall in prices.” A common assumption among investors is that deflation is bad for real economic growth and, therefore by extension, also for real dividend growth.
However, that may not necessarily be the case. For example, deflation can be separated into good deflation, which typically follows a positive supply shock, and bad deflation, which typically follows a negative demand shock. Investor fear of deflation stems from the possible consequences of bad deflation.
The common association of deflation with economic weakness is rooted in the incorrect belief that deflation signals an aggregate shortfall in demand, which lowers prices, incomes and output. But as noted above, deflation can also be a result of increased supply. Examples include improvements in productivity, greater competition, and cheaper and more abundant inputs (both labor and goods). Supply-driven deflation depresses prices while raising incomes and output.
Some investors today might be worried about the risk of deflation because of the current low U.S. inflation rate, deflation in other countries and what deflation might do to the economy, the stock market and their portfolios. To address that issue, we’ll look at the findings of a recent study on the subject.
Economic Growth & Deflation
The study “The Costs of Deflations: A Historical Perspective,” which was published in the March 2015 issue of the BIS (Bank for International Settlements) Quarterly Review, covered the period 1870 through 2013, and 38 economies. Its authors found that, in the postwar period, growth in GDP per capita has actually been higher during periods of mild deflation compared to periods of inflation.
Only during the period from 1929 through 1938, which includes the Great Depression, was there a significant difference between GDP per capita growth in periods of inflation and in periods of deflation. When looking at the whole data sample but excluding the period 1914 through 1947, which—still leaves 117 years (or 82% of the full sample)—the average growth in periods of deflation (+2.5%) and inflation (+2.4%) is virtually identical.
Growth during persistent deflationary periods (a five-year accumulative drop in consumer prices), is only somewhat lower (+1.9%). However, the authors did find that output growth is consistently lower during both property and equity price deflations.