Open up a financial newspaper and you will see the word “Deflation” again and again in articles on the general economic situation, usually in combination with the words “fear”, “concerns” or “risk”. This negative association is reinforced by the fact that Mario Draghi, president of the European Central Bank, often speaks of a “deflation risk” which must be combatted.

Given the big impact that central banks have on financial markets through their key rates and other monetary policy measures, it is important for investors to understand what influences these institutions and what they have to do with deflation and deflation risk.

To address this topic, I will present a short series of blog posts on deflation from an investor’s point of view.

The first point to understand is what exactly is meant by “deflation”, how we experience it in everyday life, what causes it, and why it occurs so seldom on a macroeconomic level. In the following posts I will address related themes, such as “deflationary spiral”, “excessive debt and deflation“, and, above all, what this means for an investor.

Deflation is defined in economics as an across-the-board, significant and sustained decline in prices of goods and services.

The main cause of falling prices is greater efficiency, i.e., the ability to offer a better product or service and/or the ability to offer it at a lower price. This phenomenon can be seen in computers and consumer electronics. An iPhone today costs about one third what an Apple Macintosh computer cost in 1984 (about USD 2500) and is capable of doing so much more.

But there are other, less well-known examples of deflation caused by enhanced efficiency. According to the Cologne Institute for Economic Research, in Germany prices of the main staple foods (butter, sugar, milk, bread, etc.) have risen in nominal terms since 1960 and even since 1991. On the other hand, in 1960 an “average” worker had to put in 51 minutes to buy 10 eggs; in 1991, nine minutes, and in 2009, only eight minutes. More generally, in 2009 a German worker had to work only one third as long in order to buy the same basket of goods as in 1960.

A further important cause of deflation – surplus supply and flat demand – is currently being illustrated in oil prices. Keep in mind, however, that demand for oil is not fully price-elastic. That means, for example, that if oil prices rise there will be only a slight decrease in driving, and if oil prices fall there will be only a slight increase in driving. Moreover, it is easy to expand or shrink supply in the very near term. The “oil tap” can be opened up or closed relatively easily.

For various political and economic reasons, oil producers are not currently on the same page and are trying to sell as much oil as possible. This has led to a global glut in oil, and the price of all types of oil has fallen by more than 50% in the last 18 months.

But why has this long- and short-term deflationary trend very seldom or never led to macroeconomic deflation? There are two reasons.

On the one hand, lower prices put more money in consumers’ hands, which they use to purchase more goods, the same goods in greater quantities, or goods of higher value. This alters the basket of goods on which basis the consumer price index is calculated. This change in consumer behaviour offsets the deflationary impact.

On the other hand deflation naturally depends on money supply and growth in money supply. And, although money is created from lending by commercial banks, it is ultimately the central banks that determine growth in money supply. In the past politics led to too much money creation which triggered (moderate) inflation.

Even so, deflation has occurred in the past. In my next blog post I will describe when and how it has done so.