Inflation means generally rising prices. Inflation typically accelerates late in the business cycle (near the peak).
Disinflation means a deceleration in the rate of inflation. Inflation typically decelerates as the economy approaches and enters recession.
Deflation means generally falling prices. Deflation is a severe threat to economic activity because it encourages defaults on debt obligations but with interest rates near zero, central banks have limited tools to combat the issue.
Inflation and the Business Cycle
| The Business Cycle | Inflation | Economic Policy | Markets |
|---|---|---|---|
| Initial recovery | Initially declining inflation | Stimulative | Short-term rates low or declining Long-term rates bottoming and bond prices peaking Stock prices increasing |
| Early expansion | Low inflation and good economic growth | Becoming less stimulative | Short-term rates increasing Long-term rates bottoming or increasing with bond prices beginning to decline Stock prices increasing |
| Late expansion | Inflation rate increasing | Becoming restrictive | Short-term and long-term rates increasing with bond prices declining Stock prices peaking and volatile |
| Slowdown | Inflation continues to accelerate | Becoming less restrictive | Short-term and long-term rates peaking and then declining with bond prices starting to increase Stock prices declining |
| Contraction | Real economic activity declining and inflation peaking | Easing | Short-term and long-term rates declining with bond prices increasing Stock prices begin to increase later in the recession |
Inflation Expectations and Asset Classes
| Inflation within expectations | Cash equivalents: Earn the real rate of interest Bonds: Shorter-term yields more volatile than longer-term yields Equity: No impact given predictable economic growth Real estate: Neutral impact with typical rates of return |
| Inflation above or below expectations | Cash equivalents: Positive (negative) impact with increasing (decreasing) yields Bonds: Longer-term yields more volatile than shorter-term yields Equity: Negative impact given the potential for central bank action or falling asset prices, though some companies may be able to pass rising costs on to customers Real estate: Positive impact as real asset values increase with inflation |
| Deflation | Cash equivalents: Positive impact if nominal interest rates are bound by 0% Bonds: Positive impact as fixed future cash flows have greater purchasing power (assuming no default on the bonds) Equity: Negative impact as economic activity and business declines Real estate: Negative impact as property values generally decline |