Inflation, Deflation, Disinflation – What’s the Difference?

Increasingly in the media, there are discussions relating to deflation: are we experiencing deflation, and is deflation worse than inflation? Occasionally, discussions of the economy refer to disinflation. This will be the first in a series of posts exploring price changes and their implications for investing.

Inflation: our old familiar friend
Inflation is a pretty familiar phenomenon for most people; we’re used to seeing prices go up generally over time. If you’re old enough, you may even remember the 1970’s, when prices spiraled dramatically upward and President Gerald Ford encouraged everyone to respond by wearing “Whip Inflation Now” lapel buttons.  To no one’s surprise, this wasn’t enough to end inflation.

Disinflation: kinder, gentler inflation
Disinflation is a convenient way of saying that the inflation rate is decelerating: prices are still going up over time, but they’re not increasing as fast as they were in some previous time period.  At the end of the 1970’s we experienced disinflation as the annual inflation rate declined from a nasty peak around 15%.  In the latter half of last year, the CPI inflation measures began signaling a decline in inflation, so we’ve experienced a less extreme period of disinflation more recently.

Deflation: hey, everything’s cheaper than it was last month
When prices deflate, not surprisingly, they drop continuously over time.  The US hasn’t experienced sustained price deflation in a long time; there were brief periods of deflation from 1949 to 1950 and again between 1954 and 1955.  Before that, the only really sustained deflation took place during the Great Depression.

After oil prices peaked last year, the overall rate of inflation began to decline.  As other factors kicked in, the world economy weakened and demand for goods has declined, encouraging producers to cut prices rather than maintain their inventories.  In Japan, wages actually declined a few percent on an annual basis.

Inflation vs. Deflation
Generally speaking, high inflation is considered a problem because it distorts the economy. People become uncertain about how much prices will go up in the future, and lenders must charge higher and higher rates of interest to preserve their after-inflation return.  Inflation can be especially disruptive if the prices are increasing faster than wages.  A small amount of inflation is usually perceived as acceptable if it’s not a big surprise.

One consequence of unexpected inflation is that those who borrow at fixed rates get to pay their lenders back with cheaper dollars.  Lenders try to lend at a rate that takes inflation into account, but if they underestimate future inflation, they lose money.  For example, imagine a situation in which everyone expects 0% inflation.  If you took out a 30-year fixed-rate mortgage that cost $1,000 a month, that would be your cost for the duration of the loan.  But suppose inflation begins to creep up at the rate of 5% a year.  After 14 years, you’d still be paying $1,000 a month, but the lender would only be able to buy half as much in goods or services with each payment in comparison to what it could buy with $1000 at the beginning of the loan.  Assuming that your wages increased at the same rate, you’d be paying half as much in real terms.  Thus, unanticipated inflation tends to redistribute wealth from lenders to borrowers.  Inflation also hurts those whose incomes are fixed, like retired people living on fixed pensions (although Social Security benefits are indexed for inflation).

During inflationary periods, central banks (in the US, the Federal Reserve) can often restrain inflation indirectly by forcing interest rates to rise. This makes it more expensive to borrow money and tends to reduce the level of borrowing and investment. A prolonged increase in interest rates, sometimes referred to as the Fed “taking away the punch bowl,” usually causes inflation to moderate. In the late 1970s, 30-year fixed mortgage rates reached double digits and went as high as 18% as a result of the Fed’s efforts to stem inflation.

Disinflation, as it only involves a decline in inflation, is generally not a big problem as long as it doesn’t take place too rapidly.  The real bugbear, in the minds of many economists, is deflation.

In a deflationary environment, prices fall over time. If everyone expects prices to keep falling, consumers and businesses have an incentive not to buy anything until they absolutely have to.  If you expect a flat-screen TV to cost $500 less in a few months, why not wait?  Demand declines and economies tend to shrink.  The expectation of continued price declines reduces the incentive for businesses to invest.

Asset prices often decline significantly during periods of deflation; whether we are experiencing long-term deflation or not is unclear, but we can say for certain that worldwide financial assets dropped in value by about $50 trillion last year.  The profound consequences of price deflation can be seen in the decline in the price of a very familiar asset: a home.

According to the Case-Shiller index for Miami, FL, the seasonally-adjusted price of a single-family home dropped 41% from December 2006 to December 2008.  A buyer purchasing a $400,000 home with a 20% down payment at the end of 2006 started with a $320,000 mortgage.  The same home is worth about $235,000 two years after purchase, so the buyer owes far more than the house is worth.  If the homeowner defaults on the mortgage, the lender must take back the home and sell at a distressed price, taking an even bigger loss on the loan.  As I noted last week, there are plenty of metro areas besides Miami where housing prices have declined severely in the last year.  The same effect can take place with other assets; as the value of loan collateral falls, lending tends to dry up as lenders find that more and more of their loans are in distress.

In a deflationary environment, those who lent money at fixed rates receive a stream of income that increases in its buying power.  If a borrower’s wages or income are declining, a fixed-rate loan can become oppressively expensive if deflation persists.  Now that real estate prices have collapsed in many areas, further deflation would produce a double-whammy: the borrower’s collateral is worth less, and his loan payments are effectively costing him more.

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Thomas Fisher, CFP®

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