Inflation, deflation or stagflation: each diagnosis implies a different treatment

September 2024 by Ana Carrisso

Since 2022, the West has been dealing with a sustained and widespread rise in prices that hasn't been seen for 40 years. The war in Ukraine has catapulted the cost of living, forcing central banks to raise interest rates at a dizzying pace. Rising prices only began to slow in mid-2023, giving way to the current context of disinflation (inflation falling, but remaining above 0%). This return of inflation came after 15 years of financial restraint, during which citizens got used to living with falling prices. Falling prices can affect the economy in three different ways, since a situation of disinflation - the one we are in now - is not the same as a scenario of deflation or stagflation. But in order to understand these phenomena, we must first understand what inflation is.

So, what is inflation after all?

According to the European Central Bank (ECB), in a market economy it is usual for the prices of goods and services to fluctuate, with some rising and others falling. Inflation occurs when prices rise across the board, so that “for every euro, fewer goods and services can be purchased today than yesterday”. In other words, inflation reduces the value of a currency over time. Think about how much a coffee cost in 2021 and compare it to what it costs today; this is a clear example of the impact of inflation on people's daily lives. Controlling price stability is the main function of central banks. Central banks act as doctors who make a diagnosis; the treatment they apply is done through interest rates, which act as a benchmark for setting the price of money. Thus, when the economy shows signs of “heating up” (rising prices), central banks apply a dose of interest rate hikes to tighten financing conditions (mortgages and loans become more expensive) and thus reduce demand, cooling prices as a result.

But what happens when prices fall?

This is where the concept of deflation comes into play, which refers to an economic context of a widespread and continuous fall in prices. Deflation affects people's wallets in a less obvious way, but is more damaging to the economy, as it ultimately leads to a contraction in growth. With evidence that prices are continuing to fall, consumers postpone their purchasing decisions; business profits fall and companies find it harder to finance themselves, so they cut costs, which may result in redundancies, since in many sectors the biggest cost is labor. Faced with this macroeconomic context, the recipe that central banks usually apply is an expansive monetary policy, cutting interest rates in order to relax financing conditions and thus encourage consumption again. Japan is an emblematic example of the impact of deflation: in the late 1980s it was the second largest economy in the world and a competitor of the US in cutting-edge technology; then growth plummeted and the nation stagnated in the 1990s, going backwards until it became the world's fourth largest economy. Inflation has only recently returned to Japan, and its central bank only started raising interest rates this year, for the first time since 2007.

Stagflation - the worst of both worlds

Stagflation is the last phenomenon that affects price stability. It refers to a situation in which parts of the economy are growing, but others are in recession, so it is also known as “the worst of both worlds”. As a result, inflation rises, but the economy doesn't grow, which drives up unemployment. The 1973 oil crisis was a clear example of stagflation which marked the lives of citizens all over the world. It is usually the most difficult scenario to diagnose and usually the one that requires the most measures to resolve. As economist John Maynard Keynes said: "Inflation is unjust and Deflation is inexpedient." "It is the duty of central banks to monitor the economy to determine what state inflation is in at any given time; the diagnosis will be fundamental to applying a different treatment to the patient and minimizing the consequences for the public."