“Disinflation” and “deflation” may sound the same but refer to very different conditions with respect to the direction and change of general price levels in the economy.
As most economies grapple with stubbornly elevated inflation globally, China recently reported a drop in its consumer price index (CPI) with July CPI inflation falling by 0.3% year-on-year, thereby bringing its economy into deflation. This triggered worries of another Japan deflation crisis that it may have rippling effects on the global economy.
Meanwhile, the US recently went through eight months of disinflation from October 2022 to June 2023, before showing an uptick yet again this July 2023.
How do we differentiate deflation and disinflation concepts?
What is deflation?
As a quick review, inflation is the rate of increase in the general price level (or price index) of goods and services at a given reference period. In the context of demand and supply, inflation usually happens when there is an increase in demand and limited supply. Case in point: last year’s supply chain bottlenecks after economic reopening post-pandemic, where supply chains were not able to catch up quickly with the rebound in demand, caused prices to soar and brought inflation to its highest levels globally. For consumers, this means fewer items can be bought with the money they have because the real value of money decreases.
In contrast, deflation happens when the supply of goods exceeds the anticipated demand. This results in declining prices versus the reference period. During periods of deflation, consumers have more cash to spend because the real value of money increases, and so does consumers’ purchase power.
What causes deflation?
1. Growth in supply–Deflation can be driven by growth in supply due to improvements in productivity, technological advancements, a drop in prices of major inputs (e.g., oil), and excess capacity.
When deflation is driven by the supply side, it is usually less worrisome and is often accompanied by economic growth. Often, the boost in productivity is faster than the rate of decline in prices, which lessens the impact on profit margins of companies, especially if demand is stable or follows through the rate of production of goods.
2. Weak demand–On the other hand, consumers can trigger the bad side of deflation when they hold back in buying goods and services for a variety of reasons, from taking advantage of trends in price drops, or increase in interest rates for savings or investment products. Consumers may also be affected by general uncertainty about the economy.
What are the effects of deflation?
When weak demand is met with excess supply, it prompts prices to go down to restore “equilibrium,” which causes profit margins to go down. If a company suffers lower profits in the long run, it may be forced to hold off on hiring more people or laying off existing ones to minimize profit losses.
And if deflation continues for prolonged periods, this may spiral into a negative domino effect in the country’s economy. There may be an increase in unemployment, contraction of demand, fall in prices, and decline in manufacturing or services output. There may also be less consumer spending due to fear of losing enough cash to buy.
Deflation may also pose consequences in a high debt environment. As purchasing power increases, so does the cost of debt and its servicing due to a rise in the real value of the currency.
What is disinflation?
Meanwhile, disinflation is the rate of change in a country’s inflation at a slower pace. It represents a period when price inflation is still positive but declining over time. This term is used when describing a period of slowing inflation. Unlike deflation, disinflation is not the mirror opposite of inflation.
An example of disinflation is when domestic inflation in the Philippines went down to 4.7% in July from 5.4% in June, which is the sixth straight month of slowing inflation since January.
What are the effects of disinflation?
1. Increased purchasing power –A disinflationary environment is a sign of a healthy economy. Disinflation reduces the effects of high inflation on households and firms because they gain more purchasing power when prices decrease.
2. Slowing growth –In some cases, a falling rate of inflation signifies slowing growth and higher unemployment. It is also possible, however, to see disinflation happening when the economy is entering a recession—a situation when the economy contracts or shrinks and as a result, unemployment usually goes up while spending and production go down.
How do deflation and disinflation impact financial markets?
Disinflation tends to have less impact on financial markets. Stock prices can hold steady even when the inflation rate is falling. If consumer confidence remains high, a reduction in consumer prices does not mean stock prices will drop. Bonds would also see an increase in value as lower inflation increases their real returns.
As the inflation rate continues to fall, a zero percent or a negative inflation can raise fears about deflation setting in. Stock and bond prices 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.
INA CALABIO is a Research & Business Analytics Officer at Metrobank in charge of the bank’s research on industries. She loves OPM and you’ll occasionally find her at the front row at the gigs of her favorite bands.
GERALDINE WAMBANGCO is a Financial Markets Analyst at the Institutional Investors Coverage Division, Financial Markets Sector, at Metrobank. She provides research and investment insights to high-net-worth clients. She takes a liking to history, astronomy, and Korean pop music.