Deflation and Disinflation

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Deflation and disinflation refer to two very different conditions with respect to the direction and change of general price levels. Deflation refers to falling prices; or in other words, the opposite of inflation (rising prices). Disinflation doesn’t refer to the direction of prices (as inflation and deflation do), but rather the rate of change: it’s a slowdown in the rate of inflation.

Put in the form of an example, deflation would be an inflation rate of -1%, while disinflation would be a change in the inflation rate from 3% one year to 2% in the next.

Disinflation 101

Disinflation is a much more common condition than deflation. While at first glance a lower rate of inflation would seem to be positive – and indeed it usually is for those who own bonds, since it increases their real (after inflation) returns – that may not always be true. In many cases, a falling rate of inflation signifies slowing growth and higher unemployment. A certain degree of inflation is a positive development that indicates an economy in reasonably good health.

However, inflation that begins to rise too quickly degrades the value of cash relative to goods and services, compelling people to spend rather than save. The increased spending fuels more inflation, which can ultimately result in hyperinflation – an extremely adverse condition that’s often accompanied by social upheaval. In one of the most extreme cases, the hyperinflation of the post-WWI German economy is widely considered to be a factor that fueled the Nazis’ ultimate rise to power.

Deflation 101

When inflation falls below zero, the economy is said to be in a state of deflation. Again, this may seem like a positive at first – if a cart full of food costs $150 today, what’s wrong with it costing $140 tomorrow? The problem is that as the prices of goods and services decrease, the relative value of cash increases.

This leads consumers to postpone spending, which in turn lead to further weakness in the economy. This can lead to a “deflationary spiral,” a self-reinforcing cycle in which falling consumption leads to reduced investment in production facilities, which in turn leads to higher unemployment and a continued downturn in consumption.

One of the most dramatic examples of this vicious cycle occurred during the Great Depression, which was characterized by double-digit deflation at its nadir. More recently, Japan struggled with deflation after its property bubble burst in 1990. The country has been unable to restore normalized inflation conditions, prompting the birth of “Abenomics” in 2013, or the policy of massive stimulus and money-printing put into action by Japanese Prime Minister Shinzo Abe.

Disinflation, Deflation, and the Financial Markets

Disinflation isn’t necessarily a negative for the financial markets. Stocks can, and often do, perform well when the rate of inflation is declining. Bonds are likely to deliver above-average returns in a disinflationary scenario since it makes central banks less likely to raise interest rates and more likely to reduce them.

Keep in mind, disinflation is positive when inflation is high.

The closer the inflation rate is to zero, however, markets will become increasingly uncomfortable with disinflation since it raises the specter of deflation.

The reason for this difference is that deflation is an extremely destructive condition for the economy and financial markets. During periods of deflation, stock prices are likely to perform poorly. This isn’t necessarily a direct result of inflation alone; it can also stem from the other trends that typically accompany deflation (such as a severe recession, social unrest, etc.) On the other hand, bonds tend to do well in periods of deflation for a variety of reasons: slow growth, reduced expectations for future inflation, favorable central bank policy, and a “flight to quality” into safer investments. Further, deflation means that lenders (i.e., bond buyers) can pay back borrowers (i.e., bond issuers) in cash that has lost value during the time of the bond’s life.

The Bottom Line

Disinflation and deflation are two very different animals. Whereas disinflation isn’t necessarily destructive as long as absolute inflation levels remain positive, deflation is. Be sure to keep this difference in mind when you hear the two terms used in the financial media.