What Is Disinflation?

What Is Disinflation?

Let me explain disinflation directly to you: it's a temporary slowing in the pace of price inflation, and I use it to describe times when the inflation rate drops just a bit over the short term.

Understanding Disinflation

You should know that disinflation is a term the Federal Reserve often uses for periods of slowing inflation. Don't confuse it with deflation, which harms the economy. While inflation and deflation deal with price direction, disinflation is about the rate of change in inflation.

Disinflation isn't problematic because prices don't drop, and it doesn't usually mean the economy is slowing. Deflation shows as negative growth like -1%, but disinflation is a shift, say from 3% to 2%. It's the opposite of reflation, where governments boost money supply to stimulate.

A healthy disinflation level is needed as it shows economic contraction and stops overheating. So, disinflation happens often and is normal in healthy economies. It benefits savers who keep their earnings.

Disinflation Triggers

Several factors can trigger disinflation in an economy. If a central bank tightens monetary policy and the government sells securities, it cuts money supply, causing disinflation.

A business cycle contraction or recession can also lead to it. For instance, businesses might hold prices to gain market share, resulting in disinflation.

Disinflation Since 1980

The U.S. economy saw one of its longest disinflation periods from 1980 to 2015.

In the 1970s, known as the Great Inflation, prices rose over 110%, with annual inflation peaking at 14.76% in early 1980.

After the Fed's aggressive policies, prices slowed in the 1980s, rising 59%. The 1990s saw 32% rise, 2000-2009 had 27%, and 2010-2015 had 9%.

Stocks did well during this, averaging 8.65% real returns from 1982 to 2015. Disinflation let the Fed lower rates in the 2000s, boosting bond returns.

Here's the risk: when inflation nears zero, like in 2015, it raises deflation fears. But in 2015, it was due to falling energy prices, so concerns were dismissed. From 2016-2020, inflation averaged 1.8%, moderated by the COVID-19 pandemic.

Disinflation Returns

Disinflation is back in 2023, after inflation hit four-decade highs last year. The CPI peaked at 9.1% in June 2022 and has since retreated, but it's still above the Fed's 2% target.

A Boston University paper on 1980s disinflation under Paul Volcker gives clues for 2023. Volcker raised rates from mid-1979 when inflation was 9%, leading to two recessions from 1980-1983 and 10.8% unemployment by 1982. Jerome Powell has hiked rates fastest since Volcker, suggesting possible downturn if history repeats.

Important Note

The federal funds rate rose from 0.25% in March 2022 to 4.5% in December 2022—the fastest increase since Volcker's era.

How Is Disinflation Different from Deflation?

The main difference is disinflation is always positive but decreasing, while deflation is always negative.

What Causes Disinflation?

Disinflation usually comes from contractionary monetary policy, like rising interest rates. It can also stem from productivity gains and technology advances.

What Happens to the Economy During Periods of Disinflation?

Past disinflation periods have led to recessions or slowdowns, with higher unemployment and lower corporate earnings.

What Happened to the Economy During the Last Period of Disinflation?

Research shows the economy had two recessions and higher unemployment in the early 1980s disinflation period.

The Bottom Line

Disinflation means a slowing inflation rate, often short-term. Supporters say it's needed to avoid overheating, but critics warn it can cause downturns or deflation as it signals contraction.

It typically results from reduced money supply via higher rates, or from productivity improvements, or slower price hikes in contractions. The 1980s period suggests the economy might contract soon if patterns hold.