Inflation, Disinflation and Deflation: What You Need to Know

August 11, 2023 06:20

On Thursday, the US Bureau of Labor Statistics released the latest inflation data from the US, with annual inflation increasing to 3.2%. This announcement followed news on Wednesday from China’s National Bureau of Statistics that annual inflation in China had turned negative, dropping to -0.3%.

We’ve heard a lot about rising prices over the last year or so, but what happens when inflation turns negative? And why do economists fear it more than high, positive inflation? Keep reading to find out.

What Is Inflation?

Whilst many may not have been very familiar with the concept of inflation a couple of years ago, most of us can now recite the definition in our sleep.

Inflation measures the rate at which prices are rising in an economy over a period of time. Consequently, inflation can also be viewed as the rate at which money is losing its purchasing power.

What Is Deflation?

Deflation is the opposite of inflation, which occurs when there is a fall in overall prices in an economy and, consequently, an increase in the purchasing power of money.

It is important not to confuse this concept with disinflation, which refers to a decrease in the rate of inflation and is currently happening in many of the world’s advanced economies. Disinflation occurs when prices are rising, but the rate at which they are rising is slowing.

For example, in June, the annual rate of inflation in the UK fell to 7.9%, down from 8.7% the previous month. This is a case of disinflation. Whilst prices are still rising on an annual basis, the rate at which they are rising has decreased.

Deflation occurs when prices are actually falling over a period of time and is illustrated by inflation turning negative, like in China earlier this week. Falling prices might sound great on the surface but that’s not necessarily the case. In fact, most economists fear deflation more than inflation. But why?

Why Is Deflation Feared?

So, what’s wrong with deflation? Surely falling prices benefits consumers, who will buy more and drive higher economic growth? These are logical points and, in the short term, a temporary fall in prices may bring benefits for an economy.

However, if deflation becomes entrenched and prices continue to fall over a sustained period of time, problems will start to arise. Falling prices will lead to lower revenue for businesses, as they receive less money for producing and selling the same amount of goods and services.

As revenue falls, businesses need to save costs, which can lead to wage reductions and, ultimately, job cuts. Falling wages and rising unemployment will result in a reduction in aggregate demand, as consumers have less money to spend. All else being equal, this decrease in demand will ultimately reinforce the downward effect on prices.

Furthermore, if prices are falling, it may lead to consumers delaying purchases where possible, in the hope that these purchases will be cheaper in the future. For instance, if you wanted to buy a car but knew that, a year from today, the car would be cheaper, you may be inclined to delay buying it.

Besides from falling demand reinforcing the downward effect on prices, consumption is the most important component of an economy’s Gross Domestic Product (GDP), which measures economic growth. Consequently, deflation can lead to a fall in consumption, an increase in unemployment and, eventually, a contraction in economic growth.

Why Are Prices Falling in China?

As many countries in the world grapple with rising prices, prices in China are moving in the opposite direction. But why?

When many of the world’s advanced economies emerged from pandemic-era restrictions, supply struggled to keep pace with soaring demand, which led to prices rising. Then Russia invaded Ukraine which sent energy prices and, consequently, inflation spiralling.

However, the case of China is very different.

As vaccination drives were successfully implemented and many countries reopened for business, China ploughed ahead with its strict zero-Covid policy, keeping domestic demand somewhat suppressed. Following a bout of social unrest at the tail-end of 2022, China abandoned this restrictive policy, leading to the much anticipated reopening of the Chinese economy.

Nevertheless, the grand reopening has thus far been thoroughly underwhelming. Not only has domestic demand remained weak, but exports are also falling, both of which have put downward pressure on prices.

And what about energy prices? Well, whilst Western countries were quick to shun Russian exports of oil and gas in response to the war in Ukraine, China took the opposite approach. Following the Russian invasion of Ukraine, China has been amping up imports of cheap energy from Russia, ensuring they remain insulated from high global prices.

Inflation vs Deflation

Typically, deflation is viewed as being worse for the economy than inflation, with central banks actively targeting a low, stable rate of inflation of around 2%.

The reason for this target is that a low rate of inflation is actually beneficial for the economy, as it encourages a certain amount of consumption over saving. Higher consumption leads to higher revenue for businesses, higher employment and higher economic growth. Nevertheless, inflation undoubtedly becomes troublesome when it gets too high, as has been the case over the last year or so.

Whilst low, stable inflation can be positive for an economy, deflation on any scale is generally viewed as negative and it can be particularly difficult to recover from, as evidenced by Japan over the last couple of decades.

The potentially negative impact of deflation on consumption, employment and economic growth is why central banks and economists tend to fear it more than inflation. For this reason, in the wake of Wednesday’s inflation data, there are likely to be increased calls for Beijing to take decisive action and intervene in its stuttering economy.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

Roberto Rivero
Roberto Rivero Financial Writer, Admirals, London

Roberto spent 11 years designing trading and decision-making systems for traders and fund managers and a further 13 years at S&P, working with professional investors. He has a BSc in Economics and an MBA and has been an active investor since the mid-1990s