How Disinflation Works: 3 Causes of Disinflation

In the world of macroeconomics, disinflation describes the phenomenon where rising prices slow down and price inflation tempers. It should not be confused with deflation, which involves a decline in the prices of goods. Rather a period of disinflation reflects a slowdown in inflation. Prices may still rise, but the risk of hyperinflation—where general price levels grow much faster than incomes—is mitigated.

Central bankers, like those in the United States Federal Reserve system, often pursue disinflationary monetary policy as a short-term way to counter high inflation without suppressing economic growth. In ideal circumstances, regulators like those at the Fed seek many years of sustained low inflation—roughly two percent per year. When inflation rates spike past this goal, regulators impose a tighter monetary policy to reign in the money supply and slow the increase in prices. In other words, their goal is disinflation.

Several factors can trigger a period of disinflation.

• Raised interest rates: A central bank like the United States Federal Reserve can raise interest rates, which tightens the money supply and makes it more expensive for banks and businesses to borrow money. By reducing the overall supply of money, the Fed promotes a slower rate of growth and—ideally—a slower rise in prices.
• Lowered energy prices: Energy prices, particularly oil prices, tend to be a key driver of inflation since they affect the manufacture and shipping of nearly all goods. A decline, or at least a halt, in energy prices can trigger a full business cycle where prices hold steady or stop their rapid growth rate.
• Lower inflation expectations: Inflation often has a direct tie to emotion and anticipation. Specifically, when consumers expect there to be more inflation, the expectation becomes a self-fulfilling prophecy. Increased demand in anticipation of future price hikes prompts raised prices, which perpetuates a spiral. By contrast, when people perceive inflation as peaking or slowing down, they may engage in disinflationary behavior. Retailers may stop the cycle of charging higher prices lest they put too great a dent in consumer spending.

Despite sounding similar, disinflation and deflation are not the same. Here are the key differences between deflation and disinflation:

• Disinflation is a slowing or plateauing of inflation. In a period of disinflation, prices may still rise, but they do so at a far lower rate than they would during a period of high inflation. Prices may also plateau. However, they do not go down.
• Deflation represents a decrease in prices. In a period of deflation, prices go down. This makes deflation the opposite of inflation. These price drops include the elements that make up the consumer price index (CPI), which is led by housing, transportation, and food. It can also result in lower stock market prices and a lower gross domestic product. Deflation tends to be a symptom of a recession or a depression. The Great Depression of the 1930s saw such a phenomenon.

One of the more famous examples of disinflation occurred at the end of the 1970s and the beginning of the 1980s when Paul Volcker led the US Federal Reserve. The 1970s had been a decade of mass inflation, with prices more than doubling from the beginning of the decade to the end. It also featured the economic phenomenon of stagflation, where wages were stagnant, but prices kept rising. Volcker, determined to stave off hyperinflation, used the power of the Fed to massively raise interest rates.

In June of 1980, the Fed under Volcker raised interest rates to a twenty percent annual rate. This quickly lowered aggregate demand. It also caused an economic slowdown, including high unemployment and a brief recession. In time, the price spiral abated (although prices didn’t go down, which would have been deflation). With inflation under control, the Fed was able to lower interest rates, and the US economy reentered a period of relative stability.

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