Inflation vs. Deflation: What’s the difference?

As prices for goods and services soared during and after the COVID-19 pandemic, we heard the term “inflation” often, with the inflation rate eventually hitting a peak at 8.1% in June 2022.¹ Since then, the pace of inflation has begun to slow down, providing a bit of relief for weary consumers.

But as the rate of inflation decreases from its recent highs, you may have come across the term “deflation,” which describes a different type of environment. As we examine both these terms, their causes, and the different ways in which they can affect your financial future, we’ll also look at ways of managing both and limiting any negative impacts.

Please note that while there are different variations of inflation and deflation (such as hyperinflation, disinflation and stagflation), this article will focus exclusively on the key concepts of inflation and deflation. 

Put simply, inflation is an increase in the price for goods and services. While a bit of inflation is considered beneficial for the economy, inflation becomes a concern when it exceeds the central bank’s target rate. In Canada, the Bank of Canada (BoC) aims to keep annual inflation around the 2% mark, with a target range of 1 to 3%.²

You’ll often hear inflation described by economists as “too much money chasing too few goods.” It comes back to the law of supply and demand. In this case, excess money supply (often fueled by low interest rates) increases demand for a limited supply of products, driving up prices.

• Demand for goods and services exceeds supply
  When demand exceeds supply, prices rise because consumers are willing to pay more to obtain goods or services. Think of the pandemic, when lockdowns and gym closures increased demand for home gym and office equipment, sending prices higher.
  
  
• Low interest rates
  When interest rates are low, people can borrow money much more easily. The excess money in circulation, in turn, can create greater demand for goods and services, and companies may respond by increasing prices.
  
  
• Increasing production costs
  When the price of raw materials increases (whether it’s gasoline, wheat, minerals or even labour), companies may pass on their increased cost to consumers, resulting in higher prices.  

• Decrease in purchasing power
  Inflation erodes purchasing power – in other words, when prices rise, your money buys less. See Illustration A, which shows the diminished purchasing power of $1,000 over the last 50 years.

_{Illustration A}

_{Source: Statistics Canada. For illustrative purposes only.}
^{Core Canadian CPI from December 31, 1973 to December 31, 2023.}

• Higher interest rates
  The Bank of Canada has a relatively limited toolkit in the fight against inflation. Their “go-to” move is usually to gradually raise interest rates, making it more expensive to borrow money. This can help to cool an overheated economy. For consumers, it makes purchases that require borrowing (such as a home, new car or major appliances) more expensive.
  
  
• Slowing down of economic growth
  Sometimes central banks “overcorrect”, meaning they raise interest rates too much, or for too long. In some cases, this may cause the economy to grind to a halt and tip into recession, also known as a “hard landing.”

As you may have guessed, deflation occurs when the prices of goods and services fall, which in turn increases purchasing power (in other words, you can buy more with the same amount of money).

While everyone loves falling prices, deflation can become a serious economic problem. A deflationary spiral can occur during periods of economic crisis, like during a recession or depression, which are associated with decreases in overall demand. If people are worried about the economy or unemployment, they may spend less so they can save more. Prolonged bouts of deflation may bring with it reduced productivity, job cuts and financial stress. During the Great Depression in the U.S., deflation was especially sharp, with prices falling nearly 7% each year from 1930 to 1933.

It’s important to note that while the rate of inflation has come down considerably since June 2022, we are not currently in a deflationary environment. Prices are still rising, but at a much slower pace than in 2022.

• Supply for goods and services exceeds demand
  When demand fails to keep pace with supply (i.e., consumers are buying less goods or services causing a surplus of inventory in the marketplace), companies may lower their prices to help stimulate demand. Falling prices across a wide range of consumer categories can trigger deflation in an economy.
  
  
• Rising interest rates
  Rising interest rates increase the cost of borrowing money, which, in turn, reduces the supply of money circulating in the economy. With less access to money, people are less willing to spend, thereby reducing demand.
  
  
• Decreasing production costs
  A decline in the price of raw materials can decrease production costs. When this happens, businesses may pass on these cost savings to consumers in the form of lower prices.

• Slower economic growth
  Falling demand for goods and services and a slowdown of consumer spending may lead to an economic slowdown, and in more extreme cases, a recession.
  
  
• Higher unemployment
  As demand for goods and services drops in a deflationary environment, companies may be forced to reduce production costs by cutting production, lowering wages and/or laying off workers.
  
  
• Lower interest rates
  As demand and productivity fall, central banks may be forced to lower interest rates in an effort to spur demand – in some more extreme cases, reducing rates to zero – or even below.

While it’s difficult to fully avoid the effects of inflation or deflation, a sound investment strategy as part of your financial plan can help you maintain your purchasing power and standard of living – now and into the future.

A Scotiabank advisor can help you create a financial plan that’s right for you and then periodically monitor and adapt it as your life and circumstances change. Learn more about financial planning and view some examples of the information you’ll receive in your plan.

To help you build a solid investment strategy, Scotiabank offers a wide range of portfolio solutions that are built to navigate a variety of market conditions, including periods of rising inflation, and align with your risk tolerance and goals.