Inflation or Deflation: What Is the Difference and How Do They Affect the Economy?

There’s a furious debate as to whether the current spike in inflation will be transitory or not. The FED has stated they are firmly in the camp of transitory inflation. However, many believe increased inflation is here to stay.

Who is right? And could we swing to the other side, going into a deflationary period? In this article, we’ll look at inflation, deflation, and indicators of both. 

What Are Inflation and Deflation?

Inflation is an increase in the prices of goods and services, which can result in a decrease in buying power if wages aren’t also rising. A decrease in buying power means that $1 today will not buy the same amount of goods and services in the future. Inflation can be caused by a country’s central bank printing money or an increase in commodities prices, which are used as raw inputs for consumer goods.

Deflation is a decrease in the prices of goods and services due to a decrease in demand. For example, if consumers are being laid off, they’ll have less money to spend, decreasing demand. Because demand for products has dropped, businesses will lower their prices. Additionally, businesses may stop making products, leading to more layoffs, which can lead to a deflationary spiral.

With an understanding of inflation and deflation, how can we use them to tell us anything about the economy?

Inflation: Leading or Lagging Indicator?

Is inflation a leading indicator? Meaning, can it forecast recessions, expansions, or disinflationary periods?

The National Bureau of Economic Research and Dr. Lacy Hunt of Hoisington Management both say that inflation is a lagging, rather than leading, indicator. The typical time between the start of a recession and the low point of inflation is about 15 quarters. That's nearly four years. 

To see why inflation lags economic performance, let's look at what happens at the start of a recovery. During this period, jobs hirings begin increasing, interest rates are low, and wages and prices aren't yet rising.

If inflation were to take off during this period, it would negatively impact the recovery. Prices and interest rates would increase, but not wages. The trade deficit would widen. All of those effects curtail a recovery.

We’ve been talking about inflation in abstract terms. Yes - prices may go up and down but are price fluctuations the truest form of inflation? Not really. However, all is not lost. The bond market holds the key to what is happening or will happen with inflation.

The Bond Market and Gauging Inflation

Some people interpret the 10 Year U.S. Treasury yield as a barometer of economic growth — meaning potentially forecasting growth. However, that isn't what the 10 year does. It is tied to inflation. Generally speaking, a rising U.S. 10 Year Treasury yield says inflation will increase while a decreasing 10 year yield says inflation will decrease.

Currently, the 10 year U.S. Treasury yield has been dropping. Despite all of the inflation talk, the 10 year is saying increasing inflation isn’t a worry. Rather, it could be deflation or even stagflation, which is more of a concern. Stagflation refers to a reduction in gross domestic production or an increase in unemployment while prices are increasing. 

When deflation occurs, unfortunately for consumers, it increases the real value of their debt, meaning consumers can have a more difficult time paying down debt.

The Debt Connection and The Velocity of Money

We know the FED is expanding its balance sheet. It’s more than doubled since the summer of July 2019. The FED’s current balance sheet sits at over $8.2 trillion. Why does this matter? The FED’s holdings incur interest. As those interest rates rise, debt servicing also rises. At some point, this can become unsustainable.

It’s not just the FED that has expanded its balance sheet. U.S. corporations hold $10.6 trillion in debt, which is 50% of GDP. This is a significant increase from the 1980 level of just $468 billion.

Debt decreases the ability to invest. Money goes to servicing debt rather than being spent on capital investment, services, or other goods. This works the same way with the consumer. Large amounts of debt mean consumers are limited in their ability to spend on goods and services.

The end result is a decrease in the velocity of money. The velocity of money refers to money chasing productive use, such as capital investment and buying goods and services. Instead of contributing to an increase in the velocity of money, debt servicing decreases it, which also suppresses inflation.

Debt levels are by far higher now than they were after the GFC. It seems unlikely that the velocity of money will get a foothold under these conditions, keeping inflation low. Should asset prices (i.e., the stock market) turn down from their extreme levels or the FED decides to begin tapering, it could be enough to push the economy into deflation.

What’s Next?

The big question is, are we heading for an increase in inflation or deflation? There are strong voices on both sides of the argument. Prices are already rising and consumers are feeling it. Many market analysts saw that inflation is here to stay because of all the money printing being done by the FED.

However, the FED says that the current inflation is transitory and is more a factor of jammed up supply chains and stimulus. Once supply chains are back to normal and stimulus has run its course, inflation will come down.

Only time will tell if the FED is right. If not, the likely scenario could be higher inflation for longer.