Disinflation: Definition, How It Works, Triggers, and Example

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.

Understanding Disinflation

Disinflation is commonly used by the Federal Reserve (Fed) to describe a period of slowing inflation and should not be confused with deflation, which can be harmful to the economy. Unlike inflation and deflation, which refer to the direction of prices, disinflation refers to the rate of change in the rate of inflation.

Disinflation is not considered problematic because prices do not actually drop, and disinflation does not usually signal the onset of a slowing economy. Deflation is represented as a negative growth rate, such as -1%, while disinflation is shown as a change in the inflation rate, say, from 3% one year to 2% the next. Disinflation is considered the opposite of reflation, which occurs when a government stimulates an economy by increasing the money supply.

A healthy amount of disinflation is necessary since it represents economic contraction and prevents the economy from overheating. As such, instances of disinflation are not uncommon and are viewed as normal during healthy economic times. Disinflation benefits certain segments of a population, such as people who are inclined to save their earnings.

Disinflation Triggers

There are several things that can cause an economy to experience disinflation. If a central bank decides to impose a tighter monetary policy and the government starts to sell off some of its securities, it could reduce the supply of money in the economy, causing a disinflationary effect.

Similarly, a contraction in the business cycle or a recession can also trigger disinflation. For example, businesses may choose not to increase prices to gain greater market share, leading to disinflation.

Disinflation Since 1980

The U.S. economy experienced one of its longest periods of disinflation from 1980 through 2015.

During the 1970s, the rapid rise of inflation came to be known as the "Great Inflation," with prices increasing more than 110% during the decade. The annual rate of inflation topped out at 14.76% in early 1980. Following the implementation of aggressive monetary policies by the Fed to reduce inflation, the increase in prices slowed in the 1980s, rising just 59% for the period. In the decade of the 1990s, prices rose 32%, followed by a 27% increase between 2000 and 2009, and a 9% increase between 2010 and 2015.

During this period of disinflation, stocks performed well, averaging 8.65% in real returns between 1982 and 2015. Disinflation also allowed the Fed to lower interest rates in the 2000s, which led to bonds generating above-average returns.

The danger that disinflation presents is when the rate of inflation falls near to zero, as it did in 2015, it raises the specter of deflation. Although the rate of inflation was near zero in 2015, concerns over deflation were dismissed because it was largely attributed to falling energy prices. As energy prices recovered in the period from 2016 to 2020, the rate of inflation picked up somewhat, averaging 1.8% during that period—moderated in 2020 by the COVID-19 pandemic.

Disinflation Returns

Disinflation has reappeared in 2023, following inflation jumping to its highest level in four decades last year. Since the consumer price index (CPI) peaked at 9.1% in June, the closely-watched metric, which measures the overall change in consumer prices, has retreated. However, inflation still sits at historically high levels, well above the Federal Reserve's target of 2%. 

A Boston University research paper published in the mid-2000s examining a sustained period of disinflation in the early 1980s under former Fed chair Paul Volcker perhaps provides the best indication of how the economy will perform under similar conditions to those years in 2023.

When Volcker assumed his position in mid-1979, he aggressively lifted the federal funds rate to tackle rampant inflation, which sat at 9%. In the following years, the economy cooled substantially, experiencing two recessions between 1980 and 1983, with unemployment climbing to 10.8% by the end of 1982. Current chairman Jerome Powell has lifted interest rates over the past 12 months at the fasted rate since Volcker to tame inflation, indicating a possible economic downturn if history repeats after a period of hawkish monetary policy.

Bottom Line

Disinflation refers to a slowing in the rate of inflation, typically when it eases over the short term. Proponents of disinflation argue that it's necessary to prevent the economy from overheating, while opponents say that it can lead to a downturn or cause deflation as it represents economic contraction. Disinflation typically arises from a reduction in the money supply that results from rising interest rates but can also come about by productivity advancements or companies raising prices at a slower pace during a contracting business cycle. A period of disinflation in the early 1980s indicates the economy may contract over the next few years if history rhymes.