Deflation

Deflation is the opposite of inflation, so it is a decrease in prices. It may be considered negative inflation, i.e. it occurs when the inflation rate falls below zero. Two most known periods of deflation are the Great Depression in the U.S. and the Japanese deflation which started in the 1990s.

These cases are presented in the chart below.

Chart 1: The U.S. CPI inflation rate (green line) and the Japan’s CPI inflation rate (red line) between 1914 (1961) and 2017.

As inflation is mainly caused by the increase in the money supply, deflation is primarily a result of the decrease in the money supply. However, the decline in the general price level may be also a result of genuine economic growth and higher productivity. This was precisely the price deflation which occurred when the gold standard was in place. As rapid growth in the supply of goods outpaced the gradual growth in the money supply, there was a mild deflationary trend in the 19th century. Such deflation is obviously positive for the economy. However, prices may fall due to hoarding of cash or bank credit deflation, which occurred during the Great Depression when there was a significant contraction in credit and money supply. This kind of deflation is often a result of long periods of artificial expansion of fiat money and its impact on the economy is subject to debate.

Deflation and Gold

There is a common view that deflation is bad for gold. The shiny metal is considered an inflation hedge, not a deflation hedge. However, gold is not just about inflation versus deflation. The yellow metal is a safe-haven asset which may shine (or languish) during both inflationary and deflationary periods.

Let’s analyze the Great Recession, i.e. an important deflationary event in the U.S. financial markets. As one can see in the chart below, the stock market declined from October 2007 to March 2008, while the price of gold continued to rally. It is true that when Lehman Brothers went bankrupt, the price of gold declined together with equities, since cash was king at that time. However, gold found a bottom and began to rally a few months earlier than the U.S. stock market.

Chart 2: Price of gold (yellow line, left axis, London P.M. Fix) and S&P 500 Index (red line, right axis) from January 2007 to December 2010.

Gold is neither a perfect inflation nor deflation hedge. Its price also depends on the market sentiment and risk aversion. When deflation is accompanied by significant economic worries and a loss of confidence in the U.S. dollar, gold should shine.