July 2004 — Q: Is there a difference between disinflation and deflation?
—Jack G., Hoosick Falls, N.Y.
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A: Yes. Disinflation is a slowing of price increases — or a drop in the inflation rate. And it’s almost always a good thing. Lower inflation generally brings lower interest rates because investors care most about the “real” return they get for their money. So if you’re getting 5 percent on, say, a 10-year Treasury bond, and inflation is running at 3 percent, your “real return” is 2 percent. That’s how much your buying power is growing. If inflation then falls to 1 percent, you can get the same real return from a bond paying 3 percent. So as inflation falls, borrowers get a break — through lower rates. And investors who bought those 5 percent bonds get higher real rate of return. That’s been the story for the U.S. economy for much of the past decade — a story that is apparently coming to an end.
Deflation is when prices actually fall — and keep falling, which can be a bad thing. A little bit of deflation here and there is good — especially if prices are falling because of better productivity. If you automate a widget factory and double production with the same number of people, your cost per widget goes down, so you can cut prices. What we’ve got now is deflation in some areas (shopping at Wal-mart) and inflation in others (a trip to the doctor or college tuition bills).
But if all prices fall — and keep falling for an extended period — that’s almost always a bad thing. First of all, your debts get larger. Say you go buy a big screen television on credit for $3000. If your neighbor buys the same television six months from now for $2,000, you both have the same TV but you owe an extra $1,000. If that effect flows through the entire economy, consumer debt (already very high) becomes a major burden, and we all cut back on spending. Since two-thirds of the economy is consumer spending, that’s not good.
Deflation is also harder to tame then inflation. The antidote for inflation is raising interest rates, and the reverse is true for deflation. But you can’t cut interest rates lower than 0%.
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