The opposite of inflation, deflation occurs when an economy experiences a sustained decline in the price of goods and services. While deflation can sound like a good thing, it can actually be worse than inflation, as consumers may become accustomed to lower prices and feel less inclined to spend money on items that might be cheaper the next day.
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Deflationary periods are characterized by broad, significant price declines. The Federal Reserve can monitor deflation by tracking prices through price indexes, such as the Consumer Price Index (CPI), which characterizes the average costs for consumers each month.
Disinflation happens when prices are still going up, just at a slower rate. Prolonged disinflation is also often accompanied by a recession, making it painful for consumers.
"Falling demand" refers to anything that changes someone's willingness to spend money on goods and services. Global recessions, fears of a worldwide recession, and a fall in the money supply are all factors that could lead to falling demand. Likewise, lower production costs allow companies to increase production, which can lead to a surplus in supply.
The word inflation has Latin roots and technically means an influx of air, first appearing in the English language in the 1890s to describe bike tires. Deflation's first known mention in an economic text was in 1919.
That psychological aspect is referred to as "the deflationary spiral." When prices start decreasing, people tend to hold on to their money to pay the lowest prices. But as prices start stabilizing, people resist increasing prices.
The stock market crash of 1929 helped trigger a period of deflation in the United States by creating a drastic decrease in the total money supply. Because of the United States' central role in the world economy, virtually every single country was impacted by the recession.
While the details are not fully agreed upon, many economists point to the Federal Reserve's tightening of the money supply as a prime culprit, leading to a significant deflationary spiral.
This tends to make products and services more affordable and normalizes the standard of living. Bad deflation usually happens when there are sudden changes to either supply or demand. Near-zero interest rates helped create the real estate bubble that sparked the Great Recession when it crashed Because deflation distorts the value of money, deflation is particularly harmful for borrowers. Low interest rates made it easy for businesses and everyday people to take on enormous debt, which exacerbated the effects of the recession.
Interest rates, the cost of borrowing money, are the primary tool the Federal Reserve uses to control inflation. During periods of deflation, setting interest rates below zero penalizes saving, encourages banks to lend more and moves more cash through the economy.
Very low inflation rates in the early 2000s in the United States and a worsening recession in Japan sparked some domestic concern over the threat of deflation. While Bernanke wasn't Chair at the time of the speech, he emphasized the Fed's role in preventing deflation.
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