Understanding disinflation and why it matters to investors

Disinflation is a term you may have heard used in the financial news, especially on topics related to broader economic trends and interest rates.

When an economy is experiencing disinflation – or the slowing of price – it means the rate of inflation is slowing. As you’ll learn below, disinflation may sound like a negative term, but it’s not necessarily a bad trend for an economy. In fact, disinflation often has positive economic consequences.

A closer look at inflation

Before we dive into the details of disinflation, we first need to fully understand inflation. Inflation is a rise in the price of goods and services in an economy. If you’ve heard someone lament that they remember a time when candy bars were 10 cents, or a soda was a nickel. Now, typical prices for a candy bar and soda are closer to a dollar, often more. This is exactly what inflation is – the rise in prices.

Depending on broader circumstances and individual perspective, sometimes inflation is viewed as a positive trend, other times it is viewed negatively. For people holding cash, inflation is a negative thing because it means they can buy less. For the average consumer, inflation trends mean that their money can buy less goods and services amid higher prices, so their purchasing power shrinks.

However, consider the people who hold material goods or have portfolios with real estate or commodities. When prices of real estate or commodities increase, so does the value of what these investors own, so they would view inflation in a positive light because it would bode well for their own personal situation.

In an economist’s eyes, a modest amount of inflation is a good thing because it keeps people spending, which creates a growth cycle. People spend instead of save money when the value of goods, instead of cash, is rising. That’s because by making a purchase earlier, they would get it at a more affordable price. Still, the key word to healthy inflation is “modest.” Too much inflation can cause economic damage if prices are so high that people can’t afford to buy what they need and the value of their money drops.

Measuring the rate of inflation

Inflation is measured by changes in a particular set of good or services. Common gauges of inflation are the Consumer Price Index (CPI) and the Producer Price Index (PPI), which are both released by the U.S. Bureau of Labor Statistics. Another popular index to measure inflation is the Wholesale Price Index (WPI), which tracks the price of goods before they are put before the consumer for resale. Some countries follow a WPI, however in the U.S. the PPI is favored.

To measure the rate of inflation, or change in inflation, you divide the current index value by the initial index value. You can make this comparison from month to month, year to year, or any other time frame. For example, in September 2020, the PPI showed that U.S. producer prices increased for the first time since March. It increased 0.4% versus a 0.2% decline in August, most of which was due to rising food costs, the data showed.

Three Types of Inflation:

• Demand-Pull Inflation: Demand-pull inflation is when demand for a particular item or service increases faster than the supply, where supply may remain the same or decline. Consider the example of oil prices. When consumers are traveling frequently and using a lot of fuel, demand and price increase. Or, when oil consortiums cut back the supply of oil, price also increases because the demand then outweighs the supply. An increase in the money supply can also trigger demand-pull inflation because people have more money to buy things, so the demand increases.

• Cost-Pull Inflation: Cost-pull inflation is when prices increase because the cost to produce the goods or services increases. For example, in homebuilding, the cost of a home could rise because the materials to construct it like lumbar and steel increase in price, or if the price of labor increases due to a healthy labor market. In this case, the builder would charge more to keep his profit the same. (Of course, a home’s price could also rise because of more demand on the consumer side, but then that would be considered demand-pull inflation.)

• Built-In Inflation: Built-in inflation is a result of the impact of rising prices causing more rising prices. It works as a cycle, where rising prices cause workers to demand higher wages so that they can maintain their standard of living. Then, with higher wages, consumers can buy more, so demand for products and services increases, causing more price increases. This spiral is the result of built-in inflation.

Inflation can often be the result of an economy seeing robust growth, as rising prices create that upcycle. Or it can be cause by a central bank like the Federal Reserve loosening its monetary policy, such as by lowering interest rates to try to stimulate the economy.

What is disinflation?

Now that you have a good understanding of what inflation is, you can easily understand disinflation. Disinflation is when the rate of inflation, or the rise of prices of goods and services in an economy, slows down. So, an economy may experience inflation, but at the same time it may also experience disinflation when the growth rate of the rise in price of goods becomes slower.

In recent history, the U.S. saw an extended period of disinflation in the from the 1980s through the early 2000s. During these three decades, price increases weren’t nearly as swift as they were during the 1970s, when prices increased more than 110% and the annual rate of inflation hit more than 14%. In contrast, the subsequent three decades starting in the 1980s saw prices increase in the double-digits.

Economic recessions and tighter monetary policies are two of the more common causes of disinflation because they cause a slower rate of spending. This is in contrast to inflation, which is driven by a booming economy and looser monetary policies.

First, recessions strain consumers’ ability to pay for goods and services, which eases demand and therefore can slow the rate of price increases. A recession is a significant downturn in the economy, marked by job losses and fear, that lasts for at least several months. U.S. recessions are declared by the National Bureau of Economic Research, which defines them as decline in economic activity spread out over the economy, including employment, income, retail sales, industrial production and Gross Domestic Product (GDP). (Traditionally, a recession had been defined as a decline of economic activity for two or more consecutive quarters.)

Monetary policies can also drive disinflation. A central bank may decide moves to slow the rate of inflation are necessary if an economy seems to be becoming overheated or inflation is rising too quickly. Afterall, if inflation gets out of control, it could have a negative impact on the economy. Or, if a government needs to sell some securities, that could result in disinflation by reducing the money supply.

How interest rates are related to disinflation

During periods of disinflation, central governments like the Federal Reserve can more comfortably lower interest rates, which in turn can stimulate the economy. Or, the Federal Reserve might raise interest rates if it feels the economy is booming and at risk of overheating and leading to inflation. The Fed typically aims for some inflation, just not too much. The Fed absolutely seeks to avoid deflation as it views deflation as something to avoid at all costs since it typically comes with significant economic pain.

The Fed & Wealth Inequality

The Federal Reserve is a controversial institution in that some experts and commentators point to the Fed’s policies in recent years as a major driver of wealth inequality. In response to the 2008 financial crisis and the 2020 coronavirus market crash, the Federal Reserve took drastic action in not just lowering interest rates, but also in buying assets (called expanding its balance sheet). These moves are considered extremely “loose” monetary policies actions with the goal of propping up the economy and the financial markets during significant market turmoil.

While most would judge these moves as successful in the event that it has helped prop up the economy and especially the market, it’s always worth asking at what cost? It’s possible that further wealth inequality is the cost. How so? Well, the Fed’s policies are extremely effective at propping up asset prices. This includes the stock market, bond markets, real estate and more. So if you own assets, it helps you! Unfortunately, if you don’t own assets, these policies don’t benefit you directly (the Fed would argue they benefit everyone indirectly since it helps stimulate the economy which leads to jobs, etc.). The problem is that while a portion of the population that doesn’t own assets not only doesn’t benefit from the asset inflation, but it is hurt even more by higher prices as cost of living rises potentially as a result of loose monetary policy. While the wealthy can shrug off cost of living increases, lower income folks simply have to pay more for basic necessities and don’t really care about the Dow Jones Industrial Average hitting new highs.

There’s no perfect answer here, but it’s a discussion that probably doesn’t get enough attention in financial circles.

How is disinflation different from deflation?

The terms “disinflation” and “deflation” sound similar and many people confuse them for the same thing. However, they are quite different.

Deflation is the opposite of inflation. It’s when the prices of goods or services in an economy decrease, and the inflation rate is less than 0%. Deflation is typically considered a negative trend for the economy and it will alarm investors and analysts because it can slow economic growth. The last time the U.S. experienced significant deflation was during the Great Depression of the 1930s.

Unemployment is among the many consequences of deflation because if companies have to lower prices, then they must make other cost-cutting measures like closing stores or laying off workers. In turn when people don’t have jobs, of course they spend less, which fuels the deflation trend, creating a cycle that is difficult to reverse. During times of recessions or depressions, consumers tend to save their money instead of spending it to try to prepare for any future losses – which also further fuels deflation. Furthermore, consumers have less incentive to spend if prices are trending downward and they might expect a better deal on the same product or service in the future.

With disinflation, the prices of goods and services don’t have to trend lower, but the rate that they are rising is slower. So, disinflation is the temporary slowdown of inflating prices. Unlike deflation, disinflation isn’t necessarily a bad thing for the economy. The rate of rising prices may slow without triggering any alarm among investors or analysts because disinflation is not necessarily harmful to an economy. If the rate of inflation slows a bit for a short period of time, it is very unlikely to have any impact on the stock market because it’s not a sign of economic turmoil.

To use an analogy, you can think of hiking up and down a mountain. When you hike up the mountain, consider this like price inflation – prices are going up. When you hike down the mountain, consider that deflation, when prices of goods and services are going down. Now imagine you are hiking up the mountain quickly, then you slow your walking pace. This is like disinflation, when prices are rising, but at a slower rate.

What causes deflation or disinflation?

Although deflation and disinflation are different economic terms, they do have similar causes. A number of causes can trigger deflation or disinflation, including a decrease in the money supply, lower consumer spending, reduced government spending or increased production.

Lower Money Supply: When you have a lower supply of money in the system, prices are generally fall because there is less money to spend. A lower money supply, along with bank failures, contributed heavily to the 1930s deflation. Again, deflation is alarming to investors because it can cause economic harm.

Consumer Spending: When consumers are spending less, the prices of goods and services tend to decline to try to meet the price point at which consumers are willing to pay.

Reduced Government Spending: When government spend less, prices tend to decline. That’s why central banks tend to spend more to try to stimulate an economy.

Improved Productivity: Companies often improve how much they can produce, say by implementing new technology. When they improve efficiency, the end result could be lower prices for two reasons. First, when consumers face more supply of a product or service, companies lower prices to try to get them to buy their particular item. Second, if it costs the company less to produce an item, it can pass that cost savings on to the consumer by lowering prices while still maintaining its profit margin and perhaps selling more of the item.

The bottom line

Disinflation, inflation, and deflation, are an important economic terms to understand whether you are investing, following the financial news media or simply comprehending economic trends.

Understanding the distinctions between disinflation and deflation is key because they have very different impacts on the economy, with deflation cause for alarm and disinflation a more positive trend, depending on other circumstances.