Defining Deflation

• Deflation may be defined as a constant decrease in prices. In the United States, it is often measured with either the Consumer Price Index (CPI), compiled by the Bureau of Labor Statistics, or the GDP Deflator, published by the Bureau of Economic Analysis. Deflation is the average decrease in prices for a variety of goods, rather than a decrease in price for a specific good. It is the opposite of inflation, which is the constant increase in prices. In contrast to inflation, however, it is less common.
  
  

Causes

• In the short run, deflation is usually caused by a period of economic stagnation, which in turn is usually the aftereffect of a long recession. In response to a fall in consumer expenditure, firms lower the prices of their goods and services in order to spurt an increase in profits. Another short-run cause may involve technological progress. Firms will only employ new technology in their production process if it decreases costs. When costs decrease, the markup of goods also falls, which in turn leads to a fall in prices. In the long run, deflation may be caused by a reduction in the money supply.
  
  

Effects of Stocks and Bonds

• Deflation tends to increase the price in bonds. Investors tend to buy bonds in order to beat the effects of a change in prices. During times of deflation, any government bond that pays a yield of more than zero percent will have a positive return with respect to the deflation rate. This positive return increases the demand for bonds, thereby increasing their prices. Price increases for bonds also reflect the lack of uncertainty in an economy during times of deflation. In uncertain times, people are less likely to invest in stocks and will instead choose bonds, which are considered "safer" assets. This reduces the price for stocks.
  
  

Effect on the Correlation of Stocks and Bonds

• The prices of stocks and bonds are said to correlate either negatively or positively, depending if the economy is currently exhibiting inflation or deflation. During deflation, although the price of bonds increases, both bond yields and stock prices fall. This is because investors tend to come to the consensus that there is less risk of a deflationary collapse. Yields and stock prices are positively correlated as a result. Some analysts use the positive correlation when assessing if the economy is in inflation or deflation. Conversely, a negative correlation is a result of inflation.