The fastest way to understand inflation
Prices are the factor that most quickly change how the economy feels to our wallets. When the cost of a shopping basket rises, the same amount of money buys fewer goods, and there’s a chain reaction that touches corporate costs and profits, interest rates, and even exchange rates. Yet terms you hear in the news—inflation, deflation, disinflation, and stagflation—can be confusing. This post distills these four core concepts in plain language, explains when each tends to occur, and what they mean for the economy and for investors.
Key inflation-related concepts
Inflation
- Definition: A sustained increase in the overall price level (e.g., the Consumer Price Index, CPI, up 3% YoY).
- Characteristics: Money’s purchasing power falls. The same amount of cash buys fewer goods and services.
- Key takeaway: Wages and prices can rise together, and central banks typically raise the policy rate to cool demand.
Deflation
- Definition: A sustained decline in the overall price level (e.g., CPI at -1%).
- Characteristics: Falling prices can trigger a vicious cycle of delayed consumption and investment.
- Key takeaway: Even if nominal rates are near 0%, real rates (Real Rate = Nominal Rate - Inflation) can rise, increasing the real burden of debt.
Disinflation
- Definition: A slowdown in the rate of inflation (prices still rise, but more slowly; e.g., 5% → 3%).
- Characteristics: “Prices are going up, but by less.” The odds of a pause or moderation in a rate-hiking cycle increase.
- Key takeaway: If inflation moderates without a sharp growth slowdown, markets often view it as a “Goldilocks” scenario.
Stagflation
- Definition: High inflation alongside economic stagnation (low growth and high unemployment).
- Characteristics: Often follows supply shocks such as spikes in commodity or energy prices.
- Key takeaway: Policy dilemma—raising rates hurts growth further; cutting rates risks stoking inflation.
When do these occur—and what are the outcomes?
When inflation takes hold
- Drivers: Demand-pull — consumption and investment surge. Cost-push — sharp increases in input costs such as commodities and wages. Monetary/fiscal easing — low rates and large fiscal support boost demand.
- Implications: Policy rate hikes, higher borrowing costs, and a squeeze on real incomes. Firms with strong pricing power and commodity-linked sectors can be relative winners.
When deflation takes hold
- Drivers: Demand collapses, deleveraging, tighter bank credit, excess capacity, etc.
- Implications: Weaker consumption and investment, rising real debt burdens, risk of prolonged stagnation. Central banks may deploy unconventional tools such as quantitative easing (QE) and forward guidance.
When disinflation takes hold
- Drivers: Supply chains normalize, energy/commodity prices fall, wage pressures ease, and the lagged effects of monetary tightening kick in.
- Implications: Potential decline in long-term yields and valuation recovery. But if disinflation is too rapid, growth may slow meaningfully—worth watching.
When stagflation takes hold
- Drivers: Geopolitical risks that spike energy and food prices, weaker productivity, and de-anchoring of inflation expectations.
- Implications: Real incomes fall, corporate margins compress, and both growth equities and long-duration bonds can struggle. Policy faces a tough trade-off between growth and inflation.
What it means for investors and how to position by asset class
In an inflationary phase
- Bonds: Rising yields pressure existing bond prices. Keep duration shorter; consider floating-rate notes (FRNs) or inflation-linked government bonds (Korean linkers; U.S. TIPS).
- Equities: Sectors with strong pricing power—consumer staples, energy, materials—may show relative strength. Poor cost control can still squeeze earnings.
- Alternatives: Commodities and gold can hedge when inflation expectations rise.
In a deflationary phase
- Bonds: Declining yields can favor high-quality long-duration bonds.
- Equities: Broad earnings weakness on softer demand. Defensives with steady cash flows—high dividend payers, staples, utilities—tend to be more resilient.
- Cash/short duration: Helps preserve liquidity and create reinvestment optionality.
In a disinflationary phase
- Bonds: If long-term yields keep falling, long-duration and high-quality bonds can benefit.
- Equities: Valuations of growth stocks can recover; investors may prefer long-duration sectors such as technology and communication services.
- Overall: If growth slows only mildly while inflation eases—a “Goldilocks” backdrop—risk assets often see multiple expansion.
In a stagflationary phase
- Bonds: Higher inflation premia are headwinds for long-duration bonds. Consider more short duration and FRNs.
- Equities: Favor energy, commodities, and companies with robust pricing power. Cost discipline is critical.
- Alternatives: Real assets, commodities, and assets with high inflation beta can provide hedges.
Quick ways to monitor the data
- Headline vs. core inflation: CPI, Core CPI, PCE, Core PCE. Core strips out volatile energy and food to better gauge the trend.
- Wages and services inflation: Wage growth, unit labor costs, and services inflation—if these are rising decisively, inflation may prove persistent.
- Inflation expectations: Breakeven inflation from inflation-linked bonds, inflation swaps, and survey-based measures (consumer and market).
- Real yield: Nominal yield minus expected inflation. Rising real yields tend to pressure growth stocks and gold.
- Demand/supply coincident indicators: Manufacturing/Services PMIs, inventory-to-orders ratios, and oil, gas, and grain prices.
Understand through simple examples
- Disinflation: If your grocery basket rose 5% last year but only 3% this year, it’s still getting more expensive—but the pace is slowing.
- Deflation: If TV prices fall -2% this year and are expected to drop another -1% next year, consumers are inclined to delay purchases.
- Stagflation: Gasoline prices surge on higher oil, while wages are flat or job security deteriorates—classic stagflation.
Practical checklist
- Trend vs. speed: Track both YoY and MoM annualized for headline and core. Changes in speed often flag turning points.
- Anchoring of inflation expectations: Watch for sharp moves in 5-year and 10-year breakevens. They signal central bank credibility and policy direction.
- Direction of real yields: Rising real yields are a headwind for high-valuation growth; falling real yields are a tailwind.
- Wage–price loop: Check whether wage growth and services inflation are reinforcing each other. This is central to persistent inflation.
- Portfolio duration: Adjust bond duration to the rate path. Shorter in inflationary periods, longer in disinflationary periods is the basic rule.
- Pricing power audit: Reassess whether holdings can pass through input-cost increases via pricing (brand strength, market power, contract structure).
- Recognize policy lags: Monetary policy can take 6–18 months to affect the real economy and inflation. Markets typically price ahead.
- Risk management: Don’t bet on a single scenario. Use diversification and hedges to prepare for multiple paths—inflation, disinflation, and growth slowdowns.
Key takeaways
- Inflation means prices are rising; deflation means they’re falling; disinflation means they’re rising more slowly. Stagflation is the “worst combo” of high inflation with weak growth.
- The drivers depend on how demand, supply, and policy interact, and the outcomes spill over to rates, wages, corporate profits, and asset prices.
- For investing, assess the regime through nominal/real rates, inflation expectations, and wage/services inflation—and improve resilience across scenarios with tools like duration management, equities with pricing power, inflation-linked bonds, and commodities.