What is Disinflation?

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.

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.

Unlike inflation and deflation, which refer to the direction of prices, disinflation refers to the rate of change in the rate of inflation.

A healthy amount of disinflation is necessary, since it prevents the economy from overheating.

CPI as a Measure of Determining Disinflation

A widely used measure of inflation is called the Consumer Price Index (CPI). The CPI measures the changes in the price level of consumer goods and services and is one of the most closely watched economic statistics among investors and the Federal Reserve. The percentage change in the CPI is used as a measure of inflation.

For example, assume the CPI was as follows for 2016, 2017, and 2018, respectively:

  • 2016 CPI: 101.7
  • 2017 CPI: 102.3
  • 2018 CPI: 102.6

If we take the percentage change of CPI from each year, the annual inflation rate can be determined. Using 2016 as the base year, the inflation for 2017 was 0.6% (102.3/101.7 – 1) and the inflation for 2018 was 0.3% (102.5/102.3 – 1). Since the inflation rates for 2017 and 2018 were 0.6% and 0.3%, respectively, it demonstrates a period of disinflation.

Causes of Disinflation

Many reasons can cause a disinflation in an economy. If a central bank wants to enforce a tighter monetary policy and the government starts selling off some of its assets, the supply of money in the economy could be limited, causing a disinflationary effect.

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Similarly, disinflation can also be caused by a contraction in the business cycle of recession. For instance, companies may choose not to raise prices to gain more significant 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.

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Example of Disinflation

The following are the CPI’s of a hypothetical economy for several years. As an analyst, your manager wants to know whether the economy experienced either inflation, disinflation, or deflation from 2013 to 2017:

  • 2013 CPI: 100
  • 2014 CPI: 101
  • 2015 CPI: 102.1
  • 2016 CPI: 102.9
  • 2017 CPI: 103.3

To determine whether the economy experienced either inflation, disinflation, or deflation, we first must determine the inflation over each year by determining the annual change in CPI between years. Doing so gives us the inflation rate for each time period. Using 2013 as a base (starting) year:

  • Inflation from 2013 to 2014: 101/100 – 1 = 1%
  • Inflation from 2014 to 2015: 102.1/101 – 1 = 1.1%
  • Inflation from 2015 to 2016: 102.9/102.1 – 1 = 0.8%
  • Inflation from 2016 to 2017: 103.3/102.9 – 1 = 0.4%

From 2013 to 2015, the economy experienced rising inflation. Inflation was 1% from 2013 to 2014 and 1.1% from 2014 to 2015.

From 2015 thereon, the country experienced disinflation. Inflation was 0.8% from 2015 to 2016 and further decreased to 0.4% from 2016 to 2017.