If inflation is the genie, then deflation is the ogre that must be fought decisively.
Christine Lagarde
Hey everyone 👋🏼
How much are you prepared to pay for olive oil?
That was the topic of conversation over dinner last week after we discovered that one of our friends had bought a brand of olive oil that had risen in price by 56% in a short space of time - she's from the Mediterranean though, so her dedication to the cause makes sense.
On a more serious note, we have all felt the effects of rising inflation and it hasn't been easy for many people.
Recently, however, things seem to be taking a positive turn. Praise be!
In March, the financial markets expected inflation to be around 3.5% a year over the next five years, but that estimate has now fallen to 2.6%.
So this week I wanted to focus your attention on two terms: disinflation and deflation.
Two terms you're likely to come across in the coming months and years, but have very different meanings and consequences.
Today, I’ll cover:
A simple explanation of disinflation vs deflation
Key risks you should be aware of ⛔️
90 second 📹 explainer for those of you with no time to spare!
🇯🇵 Japan’s ‘Lost Decade’ - a tale of deflation
What to consider in a disinflationary environment
Why we should all want ‘immaculate’ disinflation 🤞
And if you enjoy reading, please hit “❤️ like” - it really helps to know what you like and don’t like, so I can keep refining this newsletter as I go.
(Quickly) Explained…
Disinflation:
Disinflation refers to a decrease in the rate of inflation.
In other words, prices are still rising, but at a slower pace compared to before.
It doesn't mean prices are falling; it just indicates a deceleration in the rate of price increases. So, even though inflation is still positive, it's at a lower rate than in the past.
Example (illustrative): Last quarter, the inflation rate was at 4.5%. In the current quarter, it slowed down to 3.5%, showing a disinflation rate of 1%.
Deflation:
Deflation, on the other hand, is when there is a sustained and general decrease in the overall price level of goods and services in an economy.
In a deflationary environment, prices are actually falling, leading to an increase in the purchasing power of money. While this might sound beneficial for consumers at first glance, deflation can have negative effects on the economy. More on that below.
Example (illustrative): Last year, the price of a laptop was $1000. This year, the same laptop is priced at $900, indicating a deflation of 10%.
This is all great, but which one do we need to make things look rosy? 🤔
Well, disinflation is generally considered a more preferable scenario than deflation because it allows for a controlled adjustment of prices and wages, giving policymakers more tools to address the situation without causing severe economic downturns.
However, both disinflation and deflation pose risks, and moderate inflation (e.g. the Fed has a target rate of 2%) is typically the target for most central banks as it promotes economic stability and incentivizes spending and investment while avoiding the negative consequences of deflation.
Disinflation and Deflation - Key Risks 🚨
Disinflation Risks:
👀 Economic slowdown: if disinflation hits, people might cut back on spending, and businesses may hold off on investments. That can lead to a sluggish economy or even a downturn.
Job losses: disinflation could make businesses tighten their belts and lay off workers due to weaker demand, causing unemployment to rise.
⚠️ Debt trouble: disinflation makes debt harder to pay off because the value of money increases. Borrowers might struggle to repay loans.
🏷️ Expecting lower prices: If people expect prices to keep dropping, they'll put off buying stuff, which lowers demand and makes things worse.
Central bank's hands tied: When interest rates are already low, the central bank can't do much more to boost the economy, making it tougher to tackle disinflation.
Deflation Risks:
Deflationary black hole: Deflation can set off a dangerous loop where falling prices lead to less spending, hurting businesses, and causing even more price drops.
Holding off on spending: with deflation, people might wait for even cheaper prices, which hurts businesses and slows down economic activity.
Businesses hesitate to invest: deflation can make businesses wary of investing because they fear future profits will be lower due to falling prices.
Debt troubles multiply: with deflation, debts get bigger in real terms, making it harder for borrowers to repay loans, and defaults could increase.
Central bank's hands tied (again!): when deflation hits, interest rates can get stuck near zero, and the central bank's usual tools don't work well anymore.
Assets lose value: deflation can cause things like real estate and stocks to drop in value, shrinking people's wealth and confidence.
Disinflation and deflation both create uncertainty, mess with people's behavior, and give policymakers a headache.
Central banks usually try to keep a bit of inflation to avoid these troubles. A little inflation encourages spending and investment while preventing the nasty effects of deflation.
📹 Disinflation vs Deflation (in less than 90 seconds)
🇯🇵 Japan’s ‘Lost Decade’ - A Tale of Deflation
Back in the 1980s, Japan's economy was thriving. It was the envy of the world, growing at a super impressive average annual rate of 3.89%. That's way higher than what the United States was doing at the time, which was at 3.07%.
But then, trouble hit in the 1990s. The bubble burst for Japan's economy.
First, the equity and real estate bubbles popped, starting in late 1989. It was a total mess - equity values plunged a crazy 60% from late 1989 to August 1992.
And as if that wasn't bad enough, land values just kept dropping all through the 1990s, plummeting a jaw-dropping 70% by 2001.
From 1991 to 2003, Japan's economy, as measured by GDP, barely managed to grow, crawling along at a measly 1.14% annually. And that's far below what other industrialized nations were doing.
During and following the crisis, many Japanese citizens responded by saving more and spending less, which had a negative impact on aggregate demand. This contributed to deflationary pressures that encouraged consumers to further hoard money, which resulted in a deflationary spiral.
This period is commonly referred to as the "Lost Decade."
A quick side note: if you’re interested in exploring alternative investment opportunities and side hustles, paid subscribers also get access to The Alternative Investments Series. New this week:
Alternative Investment Guide #3 - Equity Crowdfunding
Interview with Dom Wells: lessons on how to acquire a digital business
What should you consider in a disinflationary environment? 🔎
First off, I think it's fair to say that the US (and many other regions) are in a precarious position when it comes to containing inflation without damaging the economy and throwing us into recession.
It’s easy to throw stones. But Central Banks have an incredible balancing act on their hands. A job I don’t envy.
That aside, in a disinflationary environment with high interest rates (roughly where we’re at), there’s a few things that might be worthwhile considering:
Purchasing power: disinflation may improve purchasing power, but high interest rates can affect borrowing costs and savings yields.
Investment diversification: high interest rates may make traditional fixed-income investments more attractive, but disinflation could still affect other asset classes. Consider a diversified investment portfolio that can withstand potential fluctuations in different market conditions.
Debt management: while disinflation can ease the burden of debt over time, high interest rates can still lead to significant interest expenses.
Savings strategies: higher interest rates can provide better returns on savings, so explore options like high-yield savings accounts to maximize your earnings.
Immaculate disinflation 🤞
I’m ending this week’s edition on a hopeful tone.
And it’s relating to the notion that we can achieve immaculate disinflation, with many economists believing we can, and of course, just as many thinking we can’t.
But what is immaculate disinflation?
“Immaculate Disinflation” is a fancy and newly coined economic phrase that means bringing down the prices of things without causing problems like people losing their jobs or businesses going bankrupt.
In short, it would would involve a “soft landing,” where inflation and the steps needed to reduce it cause minimal damage to the overall economy. In this scenario, there may still be an economic recession but it will be a mild one.
For this scenario to work, the Fed would need to avoid a wage price spiral, in which inflation leads to employees demanding higher wages, causing businesses to pay higher costs and, as a result, to increase prices, leading to more inflation.
And so far, many indicators suggest it’s possible. I should note, the skeptism comes from the fact that these types of soft landings are rare.
But both these charts make for comforting reading that it’s a scenario that could (hopefully) unfold:
We’ve not seen mass unemployment so far.
People have by and large remained OK when it comes to managing debt.
Thanks so much for reading.
If you enjoyed this post - hit the “❤️ like” button - I’d really appreciate it!
Jason
DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.