Inflation and Deflation: Definition, Causes, Effects

Why Rising Prices Are Better Than Falling Prices. Yes, Really.

Inflation is when prices rise, and deflation is when prices fall. You can have both inflation and deflation at the same time in various asset classes. When taken to their extremes, both are bad for economic growth, but for different reasons. That's why the Federal Reserve, the nation's central bank, tries to control them. Here's how to recognize the signs of rampant inflation and deflation, and how to protect your finances.

How to Tell the Difference Between Inflation and Deflation

There are fives types of inflation. The worst is hyperinflation. That's when prices rise more than 50 percent a month. Fortunately, it's rare. That's because it's only caused by massive military spending. On the other end of the scale is asset inflation, which occurs somewhere nearly all the time. For example, each spring oil and gas prices spike because commodities traders bid up oil prices. They anticipate rising demand at the pump thanks to the summer vacation driving season. 

The third type, creeping inflation, is when prices rise 3 percent a year or less. It's somewhat common. It occurs when the economy is doing well. The last time it happened was in 2007.

The fourth type is walking, or pernicious, inflation. Prices increase 3-10 percent a year, enough for people to stock up now to avoid higher prices later. Suppliers and wages can't keep up, which leads to shortages or prices so high that most people can't afford the basics.

The fifth type, galloping inflation, is when prices rise 10 percent or more a year. It can destabilize the economy, drive out foreign investors, and topple government leaders. It's a result of exchange rate fluctuations.

Deflation is when prices fall, but it can be difficult to spot. That's because all prices don't fall uniformly.

During overall deflation, you can have inflation in some areas of the economy. In 2014, there was deflation in oil and gas prices. Meanwhile, prices of housing continued to rise, although slowly. That's why the Federal Reserve measures the core inflation rate. It takes out the volatile price changes of oil and food.

Examples

The United States had walking inflation in the late 1980s and early 1990s. Inflation reached a peak of 6.1 percent. Galloping inflation occurred in the 1970s and early 1980s. That was due to President Richard Nixon's economic policies. First, he instituted wage-price controls, which created stagflation. To curb that, he took the dollar off the gold standard, which only spurred inflation even more as the dollar's value declined.  A review of U.S. inflation rate history shows many other examples.

Japan's economy has ongoing deflation. It began in 1989, when the Bank of Japan raised interest rates. That sent demand for housing downward. As prices fell in other areas, businesses cut back on expansion, and people stopped spending and started saving more. The population grew older, without enough young people to replace workers who retired. Older people bought less, since it's the young who start families, buy new homes, and purchase furniture.

The government tried expansionary fiscal policies. That only doubled its debt without restoring confidence. Japan still struggles to escape this liquidity trap.

Causes 

There are three causes of inflation. The first, demand-pull inflation, occurs when demand outstrips supply. The second is cost-push inflation, which is when the supply of goods or services is restricted, while demand stays the same. For example, since there is a shortage of highly skilled software engineers, their wages skyrocket. 

The third, overexpansion of the nation's money supply, is when too much capital chases too few goods and services. It's caused by too-expansive fiscal or monetary policy, creating too much liquidity.

Deflation is usually caused by a drop in demand. Fewer shoppers mean businesses have to lower prices, which can turn into a bidding war.

It's also caused by technology changes, such more efficient computer chips. Deflation can also be caused by exchange rates. For example, China keeps its currency's value low compared to the U.S. dollar. That allows it to underprice U.S. manufacturers, lowering prices on its exports to the United States.

How Are Inflation and Deflation Controlled in the U.S. Economy?

Since oil and food prices can be so volatile, they are omitted from the core inflation rate. In January 2012, the Fed decided to use the core PCE price index as its measurement of inflation. If the core inflation rate rises above the Fed's 2 percent target inflation rate, the central bank will launch a contractionary monetary policy. That raises interest rates, reducing the money supply and slowing demand-pull inflation.

The Fed usually only addresses general inflation. But contractionary monetary policy can attack asset inflation as well. High interest rates can slow demand for housing if asset inflation poses a threat. Unfortunately, the Fed didn't raise interest rates during the housing boom in 2005. It thought that asset inflation would remain confined to housing and not spread to the general economy. True enough, inflation didn't spread. When the housing bubble burst, it led to the subprime mortgage crisis and the 2008 financial crisis. Inflation isn't really a threat because the Fed has become very good at controlling inflation.

Deflation Versus Inflation: Which Is Worse?

Deflation is worse because interest rates can only be lowered to zero. As businesses and people feel less wealthy, they spend less, reducing demand further. Prices drop in response, giving companies less profit. Once people expect price declines, they delay purchases as long as possible. They know the longer they wait, the lower the price will be. This further decreases demand, causing businesses to slash prices even more. It is a vicious, downward spiral.

What Inflation and Deflation Mean to You

Inflation lowers your standard of living if your income doesn't keep pace with rising prices (and it rarely does). However, if inflation is around 2 percent, then people buy things now before prices go up in the future. That can spur economic growth. Even when it's mild, inflation always impacts your life.

How to Protect Yourself 

Both inflation and deflation are under control in the United States. But you can keep an eye on inflation and deflation with the monthly Consumer Price Index report published by the Bureau of Labor Statistics. Here's the current inflation rate. It's also measured by the Personal Consumption Expenditures price index, which includes more business goods and services than the CPI.  

Two bonds offered by the U.S. Treasury provide built-in ways to protect yourself from inflation. Both the Treasury Inflated Protected Securities and the Series I Bonds automatically rise in value along with inflation. If you're anxious about inflation, you'll get peace of mind if you own some of these. On the other hand, the best protection is a well-diversified portfolio that includes stocks. That's because the stock market historically outperforms inflation. If you're retired or otherwise can't afford a downturn, then you might want more TIPS or I Bonds than stocks. 

What about gold? It's used as a hedge against inflation, but gold prices are affected by a lot of other things as well. Since it's traded on the commodities market, it's more volatile. As a result, its prices don't rise and fall with other asset classes. That makes it good for a diversified portfolio. That the main reason why you should invest in gold.