For most consumers, the concept of inflation is all too familiar. Inflation describes the process of increasing the prices of goods and services over time, thereby decreasing the purchasing power of each dollar. Deflation, on the other hand, refers to falling prices and lowering the cost of living. So what do we mean by disinflation?
What does disinflation mean?
Disinflation refers to the process of increasing the prices of goods and services over time, but at a slower pace than they have done in the past. For example, if the year-on-year inflation rate hovers around 5% for several months, then drops to 4%, then to 3% in subsequent months, the economy could be described as experiencing disinflation – prices continue to rise in general, but they do so at a slower pace.
Disinflation vs. deflation: what’s the difference?
It is important not to confuse disinflation with deflation. Deflation describes a period of falling prices – goods and services become cheaper and the cost of living goes down. During disinflation, on the other hand, prices rise, but not as rapidly as before.
Take a look at the charts below, which plot the Consumer Price Index (an indicator of average prices for consumer goods and services) on the Y axis and time on the X axis.
The first graph, in which the slope of the line remains positive but becomes less steep, illustrates a period of disinflation. The second graph, in which the slope of the line actually becomes negative, illustrates a period of deflation.
What causes disinflation?
Disinflation is a normal part of the business cycle and tends to occur after periods of rising inflation. Often, disinflation occurs when the Federal Reserve has instituted quantitative tightening measures in order to slow the rise in inflation. Quantitative easing is the process of reducing or tightening the money supply.
Recessions (or more minor economic contractions) can also lead to disinflation, as companies refrain from raising prices in order to attract and retain customers during times when discretionary spending has fallen.
Example of disinflation: the early 1980s
During a period known as the Great Inflation, consumer prices roughly doubled during the 1970s due to the abandonment of the Bretton-Woods system, an oil embargo, a crisis energy and other factors. In 1979, Paul Volcker became Chairman of the Federal Reserve and launched a campaign of quantitative tightening in hopes of bringing inflation down to a reasonable level.
Sometime in 1981, Volcker raised the federal funds rate to an all-time high of 19%. His efforts caused a recession and soaring unemployment, but ultimately succeeded in reigniting a period of disinflation that brought the inflation rate down to near the Fed’s 2% target in 1983.
Is disinflation good or bad? What impact does this have on the economy?
Disinflation is not a bad thing because a positive inflation rate implies that the economy is growing, which is generally considered a sign of good health. One of the Federal Reserve’s two main goals is to maintain an inflation rate of around 2%, so if the inflation rate starts to fall towards that level after a period of higher than usual inflation , the country’s central bank sees this as a positive sign.
That being said, unemployment often increases during periods of disinflation, and the other half of the Fed’s mandate is to keep unemployment as low as possible, so if disinflation continues too long before the rate stabilizes, there may be negative consequences. Overall, if disinflation is short-lived, especially after a period of rising inflation, there’s really no need to worry. In fact, brief periods of disinflation can relieve consumers and help boost spending and economic optimism.
Frequently Asked Questions (FAQ)
Below are answers to some of the most common questions investors have about disinflation.
What is the impact of disinflation on the stock market?
During periods of rising inflation, investors tend to avoid riskier securities like stocks and move their money to more stable investment vehicles like bonds, so bear markets (lower prices shares) are common.
Disinflation, on the other hand, signals a slowdown in the rise in the rate of inflation, which instills optimism in investors. This usually allows buyers to regain control, causing stock prices to rise.
How does disinflation affect the CPI?
The consumer price index is simply a measure of the average cost of goods and services, so the CPI continues to rise during periods of disinflation, it just does so at a slower rate than it has done in recent months or years. Deflation, on the other hand, means a real decrease in the CPI.
What is the relationship between disinflation and real interest rates?
A real interest rate is determined by subtracting the rate of inflation from a nominal interest rate (the real interest rate specified by a bank). For example, if someone earns 1% interest on their savings account, but the inflation rate is 3%, their real interest rate is -2%. In other words, they lose purchasing power by keeping their money in a savings account at the current inflation rate.
Disinflation occurs when the inflation rate drops but remains positive. This causes real interest rates to rise. For example, using the example above, let’s say inflation fell from 3% to 2% – the individual with the savings account would now have a real interest rate of -1%. They would still lose purchasing power on their savings due to inflation, but not as quickly.