Consumer prices for goods and services can often be a good indicator of what’s happening in an economy. Deflation and disinflation are two terms that some people mix up at times but mean very different things with regard to price trends. Deflation is effectively the opposite of inflation and is marked by a period of falling prices. Disinflation, on the other hand, measures the speed at which inflation rises or falls. When looking to set the right asset allocation in your investment portfolio during a deflation, talk to a financial advisor to make sure you’re maximizing your potential results.
What Is Deflation?
Inflation is a period of continually rising prices for goods and services. Deflation, meanwhile, is a period of price decline. An economy can experience deflation when the inflation rate drops below 0%.
Declining prices might sound like a good thing, especially after an extended period of inflation. But deflation can be problematic for an economy as a whole if it’s a symptom of a broader slowdown or downturn. When deflation sends prices down, spending doesn’t automatically increase. In fact, consumers might decide to hang on to more of their cash to see just how low prices can go.
When consumers spend less, companies may begin to produce less if supply exceeds demand. If profits begin to fall, those same companies may begin to reduce their workforce. Unemployment rising can add fuel to the fire, so to speak, and extend an economic downturn.
There’s no single cause for deflation. It can happen as the result of the interaction of several different factors, including cutbacks in consumer spending and government spending, corporations reducing their investments and an overall decrease in the available money supply as individuals and businesses hoard cash.
What Is Disinflation?
Disinflation refers to a downward shift in the inflation rate. Prices still remain higher, though the pace at which those price increases occur begins to change. In some cases, the inflation rate can drop, though it still remains positive. For instance, you can have disinflation if the inflation rate moves from 9% to 8% year-over-year.
Some inflation is generally viewed as being a good thing since it signals a healthy economy. Likewise, disinflation is often viewed in a positive light. If the inflation rate is gradually trending down over a period of several months or years, it’s not necessarily an indicator that the economy is slowing down.
It’s possible, however, to see disinflation happening when the economy is in or entering a recession. Recessions happen when the economy contracts or shrinks and as a result, unemployment usually goes up while spending and production go down. Governments can also influence inflation by taking steps to reduce the money supply in order to offset the negative effects of a recession.
Disinflation vs. Deflation: What’s the Difference?
Disinflation and deflation measure similar things in different ways. When you have disinflation, it’s because the rate of inflation is slowing down or decreasing over time. The inflation rate remains positive but it may begin to trend down from one measured period to the next. For instance, you can track disinflation quarterly or from year to year to see how the inflation rate is moving.
Deflation happens when the overall level of prices for consumer goods and services falls. Or more specifically, it’s when the inflation rate is negative. Both inflation and deflation are measured by the Consumer Price Index (CPI), which tracks prices for a broad range of consumer goods and services.
Some of the key indicators of deflation include:
Consistently falling prices
Decreased economic output
Cutbacks in consumer and corporate spending
At its core, deflation can be the result of significant shifts in supply and demand. There’s generally no limit to how low prices can go if demand outpaces supply.
Disinflation, meanwhile, signals that prices are falling back to customary levels and that inflation is easing. If supply and demand to continue to move at a consistent pace, relative to one another, then you may not see any immediate impacts to the economy with regard to rising unemployment or a slowdown in production.
How Disinflation and Deflation Impact Investors
From a consumer perspective, falling prices are generally seen as a positive because it means your money tends to go further. But what if you’re an investor? What are the possible side effects of disinflation vs. deflation on financial markets?
Disinflation, for the most part, tends to have less of an impact on outcomes. That’s because stock prices can hold steady even when the inflation rate appears to be falling. As long as consumer confidence remains high, a reduction in consumer prices doesn’t mean that stock prices will drop.
As the inflation rate continues to fall, however, you may begin to see rumblings in the financial markets. An inflation rate of 0% or a negative inflation rate can raise fears about deflation setting in. When an economy experiences deflation, stocks can become more volatile because as mentioned, there is no set bottom that consumer prices can hit. Uncertainty over deflation can lead to uncertainty about the broader state of the economy, which can cause prices to fall even further.
In some cases, deflation can result in declines in the financial market when accompanied by extreme situations, such as far-reaching recession or a period of increased social unrest. In those instances, it can be challenging for governments to establish a monetary policy that will curb deflation and produce a healthy inflation rate once again.
How to Invest for Disinflation or Deflation
You might be a pro at investing for inflation but it’s also important to understand what strategies might work best during periods of deflation. For example, when prices are falling steadily and consumers are spending less, stocks can lose some of their appeals. Bonds, on the other hand, could be a safe haven for disinflation or deflation.
When economic growth begins to lag, that can lead governments adopt monetary policies that are favorable to bond investors. Specifically, central banks may reduce interest rates. Bond yields and interest rates have an inverse relationship, which means that if rates fall, bond investors may realize higher returns from those investments.
Certain types of bonds may be a safer bet than others during deflation. For instance, you may want to favor bonds from issuers with a higher credit rating, which can carry lower default risk. While junk bonds could produce higher returns, you’re also taking much more risk with them, something you may not be comfortable with if the economy is shaky.
The Bottom Line
Understanding how disinflation ad deflation differ matters if you’re interested in how consumer price movements may affect your portfolio. Between the two, it’s important to remember that deflation has the potential to be more harmful, though it’s far less common than disinflation. Working with the right financial advisor can give you the confidence to invest for growth during deflation or any other potential difficult investing event.
Consider talking to your financial advisor about the differences between disinflation vs. deflation and how they might affect you. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
In addition to disinflation and deflation, there are other economic concepts to be familiar with. Stagflation, for instance, happens when you have rising inflation paired with increasing unemployment. Hyperinflation is marked by an extreme rise in prices over a fairly short time period.
©iStock.com/DjordjeDjurdjevic, ©iStock.com/Vladimir Vladimirov, ©iStock.com/gesrey