Deflation and stagflation

STEP 1Telling three terms apart

In Lesson 8 we said that 'the inflation rate getting lower' and 'prices falling' are different things. We start by sorting out this difference with exact terms.

Three terms that look alike but are completely different

Disinflation is the process in which a high inflation rate comes down, as the US and Korea experienced after 2023. This is exactly what central banks want when they raise interest rates. Deflation goes one step further: the price level actually falls. Stagflation combines 'stagnation' and 'inflation', a state in which the economy and prices get worse in opposite directions.

Why is falling inflation bad?

There is one more reason deflation is frightening: the burden of debt grows. Even when prices and wages fall, the amount borrowed stays the same, so the debt to be repaid becomes effectively heavier. Companies and households spend less because they are paying down debt, which cuts demand even more. It is also hard to cut interest rates far below 0%, so the tools available to the central bank are limited. That is why central banks around the world set an inflation target a little above 0%, such as 2%, to leave room to avoid falling into deflation.

Why does deflation happen?

It is easy to think about using the supply and demand of Lesson 3. There are two ways prices can fall. One is when demand shrinks. When a bubble bursts or debt is so heavy that companies and households sharply cut spending, unsold goods pile up and prices fall. The spiral we just saw mainly arises along this path. The other is when supply improves. When technological progress cuts production costs sharply and prices fall, goods simply get cheaper without incomes falling, so it often does not lead to a spiral.

So when you hear that "prices are falling," look at the reason first. Depending on whether prices are falling because demand collapsed or because productivity improved, the meaning for stocks is the exact opposite. Deflation caused by collapsing demand drags down company sales and profits together.

STEP 2Growth × prices: four phases

The terms in STEP 1 can actually be arranged on one page using two axes. Let's put the business conditions (growth) of Lesson 5 on the horizontal axis and the prices of Lessons 7–9 on the vertical axis.

See it in a chart: tap the four boxes

The central bank's dilemma differs by phase

In two of the four boxes the central bank's job is relatively clear. In the overheating phase it raises rates to cool both growth and prices, and in the deflation/recession phase it cuts rates and releases money to warm both growth and prices. Growth and prices move in the same direction, so there is a single prescription.

This is where you can see why stagflation is hard. If the central bank raises rates to stop inflation, an already weak economy gets worse; if it cuts rates to rescue the economy, it pours oil on prices. The two goals call for opposite prescriptions. That is why stagflation usually arises when 'costs' suddenly jump, as in an oil supply shock, and the longer it drags on, the more often the central bank has chosen to bring prices under control first, even at the expense of the economy. The US in the 1970s–80s in STEP 3 is the classic example.

Goldilocks comes from the fairy-tale 'soup that is not too hot and not too cold', and it is the most comfortable phase, with decent growth and stable prices. In such times, though, optimism grows and the multiple of Lesson 1 tends to climb, and the shakeout can be bigger when the economy moves into the next phase.

How to tell which box we are in now

To actually use the four boxes, you have to put numbers on the two axes. Growth on the horizontal axis is read from the GDP growth rate in Lesson 4, the PMI and leading indicators in Lesson 6, and the employment data you will learn in Part 4. Prices on the vertical axis are read from CPI and core inflation in Lesson 8 and PCE in Lesson 9. What matters is direction rather than level. Even if growth is 2%, if it is coming down from 3% you are moving left; even if inflation is 3%, if it is coming down from 5% you are moving down.

Another point: the economy doesn't stay in one box for long and moves between boxes. Goldilocks turns into overheating, and overheating passes through tightening into a slowdown. If the business cycle in Lesson 5 was a story about moving horizontally, this map adds the vertical axis of prices to it. Markets often price in 'which box comes next' before the box we are in now.

STEP 3Japan and the 1970s US

What did two of the boxes on the map, deflation and stagflation, actually look like? Let's check with real data from two countries.

Two countries, two difficult eras

Switch cases with the buttons, and tap a bar to see that year's numbers.

Japan: 30 years of falling prices

In the late 1980s Japan's stock and real estate prices inflated massively, and the bubble burst in the early 1990s. After that, banks and companies spent less as they cleaned up bad assets, and households tightened their wallets too, so the inflation rate sank to around 0%. According to OECD data, in 131 of the 216 months from 1995 to 2012, prices were lower than a year earlier. The spiral of STEP 1 really did last a long time.

The stock market also went through a long winter. The Nikkei 225 hit its record high of 38,915.87 on Dec 29, 1989, and did not surpass it again until 34 years later, on Feb 22, 2024 (39,098.68). This was the result of earnings that did not grow (the earnings knob) and of the excessively high bubble-era multiples shrinking for a long time (the multiple knob). On the other hand, with interest rates held very low, assets with fixed interest such as government bonds held up relatively well.

US: the 1970s, when inflation and unemployment rose together

In the 1970s, two oil shocks sent oil prices soaring in the US, and inflation and unemployment rose together. Inflation averaged 11.0% in 1974, and in 1975, with prices up 9.2%, unemployment rose to an annual average of 8.5%. When oil prices jumped again in 1979, inflation in 1980 averaged 13.6% for the year and hit 14.8% in March on a monthly basis.

In the end the Fed chose to bring prices under control even at the cost of the economy. The monthly average federal funds rate climbed to 19.1% in June 1981, the economy fell into a deep recession and the unemployment rate rose to 10.8% in November 1982. The price was that inflation came down to an annual average of 3.2% in 1983. It shows how costly it is to end stagflation.

For stocks, it goes like this

Looking at the four phases again through the two knobs of Lesson 1 makes it clear why stagflation is the trickiest. The economy worsens and company earnings fall (earnings knob ↓), and prices push interest rates up so the multiple falls too (multiple knob ↓). Both knobs are pressed down together. In a deflation phase earnings fall but interest rates are low, so long-term government bonds are relatively strong, and a Goldilocks phase is the most favorable environment for stocks, with growing earnings and little interest-rate pressure.

A simplified table of tendencies that generally appeared in the past. In reality phases appear mixed together, and even within the same phase assets often moved differently.

You can check which direction growth and prices are each heading now under 'Current phase' on the Macro Map, and how rising prices and improving growth affect each sector on the impact map.

Phases do not divide cleanly. When growth is slowing while inflation is coming down, there are many borderline periods, such as a slowdown within disinflation. Please use the four boxes not as the right answer but as a compass for roughly locating where we are.