What Is Disinflation?
Disinflation is a temporary slowing of the pace of price inflation and is used to describe instances when the inflation rate has reduced marginally over the short term.
Key Takeaways
- Disinflation is a temporary reduction in the rate of price inflation over a brief period.
- It does not indicate a decrease in prices but a slower inflation rate.
- Healthy disinflation prevents economic overheating.
- When inflation approaches zero, the risk of deflation arises.
- Disinflation has made a notable return in 2023 following record-high inflation levels in 2022.
Understanding Disinflation
Disinflation is often referenced by the Federal Reserve (Fed) during periods of slowing inflation. It should not be confused with deflation, which can be detrimental to the economy. While inflation and deflation are concerned with the direction of prices, disinflation focuses on the rate at which inflation changes.
Disinflation is typically not problematic as it does not indicate an actual decrease in prices, nor does it signal an economic slowdown. Disinflation contrasts with reflation, which occurs when a government stimulates economic growth by increasing the money supply.
A healthy amount of disinflation is beneficial as it represents economic contraction and helps prevent the economy from overheating. Such instances aren’t uncommon and are seen as normal during healthy economic phases. Disinflation benefits specific segments of the population, for instance, those who prefer saving their income.
Disinflation Triggers
Several factors can cause an economy to experience disinflation. When a central bank implements a tighter monetary policy and the government starts selling off its securities, it can reduce the money supply, leading to a disinflationary effect.
Similarly, contractions in the business cycle or recessions can lead to disinflation. For example, businesses may choose not to increase prices in an effort to capture more market share, resulting in disinflation.
Disinflation Since 1980
The U.S. economy experienced one of its longest periods of disinflation from 1980 through 2015.
The 1970s experienced rapid inflation known as the Great Inflation, with prices rising over 110% during the decade. By early 1980, the annual inflation rate peaked at 14.76%.
Following sharp monetary policies by the Fed to combat inflation, the pace of price increases slowed in the 1980s, with a 59% rise throughout that decade. Prices increased by 32% in the 1990s, 27% from 2000 to 2009, and 9% from 2010 to 2015.
During this time, stocks performed well, averaging 8.65% real returns from 1982 to 2015. Disinflation also enabled the Fed to lower interest rates in the 2000s, leading to above-average returns from bonds.
The danger of disinflation emerges when the rate falls near zero, as it did in 2015, raising the threat of deflation. Despite inflation nearing zero in 2015, deflation fears were dismissed, attributing the rate primarily to lower energy prices. As those prices recovered, inflation averaged 1.8% from 2016 to 2020, slightly curbed by the COVID-19 pandemic.
Disinflation Returns
Disinflation reappeared in 2023 after inflation peaked at its highest level in four decades in 2022. The Consumer Price Index (CPI) peaked at 9.1% in June 2022, and has since eased, yet inflation remains well above the Fed’s target of 2%.
A research paper from Boston University examines a sustained period of disinflation in the early 1980s under then-Fed chair Paul Volcker, shedding light on potential economic outcomes under similar conditions today.
When Volcker assumed his position in 1979, he aggressively increased the federal funds rate to curb rampant inflation. The following years saw significant economic cooling and recessions, with unemployment soaring to 10.8% by the end of 1982.
Current chairman Jerome Powell has raised interest rates at the fastest pace experienced since the Volcker era to combat inflation, suggesting potential economic downturns if history repeats. The federal funds rate increased from 0.25% in March 2022 to 4.5% in December 2022, matching Volcker-era pace.
Differences Between Disinflation and Deflation
The key distinction between disinflation and deflation is that disinflation represents a slowdown in inflation, whereas deflation indicates an actual decrease in price levels. Disinflation is characterized as positive but slowing; deflation, however, is inherently negative.
Causes of Disinflation
Disinflation typically results from contractionary monetary policy, such as hiking interest rates. Furthermore, increases in productivity and technological advancements can also trigger disinflation.
Economic Impacts of Disinflation
Periods of disinflation have historically led to economic slowdowns or recessions with higher unemployment rates and lower corporate earnings.
Historical Insights from Recent Disinflation
Research from past disinflation periods, like the one in the early 1980s, reveals that the economy experienced significant downturns and heightened unemployment rates.
Conclusion: Managing Disinflation’s Balancing Act
Disinflation signifies a reduction in the rate of inflation, indicating economic slowdowns over the short term. Advocates believe disinflation is necessary to prevent overheating, while critics fear it may induce economic contractions or deflation.
Disinflation generally stems from reduced money supply triggered by rising interest rates, but productivity advancements or controlled price increments amidst a contracting business cycle can also lead to disinflation. Insights from the early 1980s indicate potential economic contraction over the forthcoming years if historical patterns reemerge.
Related Terms: inflation, deflation, monetary policy, Federal Reserve, interest rates.
References
- U.S. Bureau of Labor Statistics. “Historical Consumer Price Index for All Urban Consumers”, Page 2.
- U.S. Bureau of Labor Statistics. “Consumer Prices Up 9.1% Over the Year Ended June 2022, Largest Increase in 40 Years”.
- Boston University. “The Incredible Volcker Disinflation”, Page 1.
- U.S. Bureau of Labor Statistics. “Unemployment Continued to Rise in 1982 as Recession Deepened”.
- Board of Governors of the Federal Reserve System. “Open Market Operations”.
