Steve Bain

What is Disinflation in Economics?

Disinflation is the term used by economists to describe a situation where there is some positive amount of inflation, meaning that the price level is rising, but that the rate of that increase is coming down.

The term is generally associated with an improvement in the economy as it moves back towards normality after a period of excessive price rises, but this is not necessarily the case. Disinflation also occurs when things are getting worse e.g., during a period of 'galloping inflation' with volatile periods of both rising and declining inflation rates. In these dire circumstances it can be a prelude to hyperinflation.

The most famous period of disinflation came during the 1980s after a very volatile economic period in the 1970s. This is sometimes referred to as Volcker disinflation, and I have given details about it in a section below.

What Causes Disinflation?

During a typical expansionary phase in the economy, that pushes output a little too high a little too quickly, there will likely be an increase in GDP that takes unemployment below its natural rate. This will likely cause some acceleration in the rate of inflation and, in order to resolve this problem, the Fed will act to tighten monetary policy and raise interest rates.

This will cause the economy to slow down and bring the unemployment rate down to its long-run sustainable rate. As output slows, the inflation rate will also start to fall i.e. disinflation will occur. 

Disinflation during a period of galloping inflation, on the other hand, is caused by fluctuations in many economic variables as well as amplified reactions to changes in mere expectations about economic policy. Changes in expectations about the Federal Funds Rate, for example, will have a significant impact on the whole structure of interest rates in the economy and thereby influence aggregate demand.

Additionally, the Bullwhip Effect in the supply-chain can have a significant impact on prices due to the way that production levels experience volatility. This causes inventory levels to fluctuate wildly, and retailers to fluctuate between cut-price clearance sales and higher pricing when supplies are difficult to obtain.

Disinflation vs Deflation

At some point, if a trend towards disinflation continues long enough, it will eventually turn into deflation. This happens at the point that inflation turns negative meaning that the price level is falling.

Economists often disagree in their assessments of how far disinflation will continue and whether it poses a threat of deflation, but in most situations it is rare for things to go that far. In the event that they do go that far, it usually only lasts for a short period before prices stabilize and then start to rise again.

In any run-of-the-mill recession the Federal Reserve Bank will act quickly to prevent deflation because, after the ravages of the Great Depression, central banks have an almost irrational fear of falling prices. That's not to say that deflation is nothing to fear, but the Fed's scales are tipped way too far in the direction of stopping it all costs from any Austrian economist's point of view.

Of course, in the 2020s, economic circumstances cannot be described as run-of-the-mill, and the disinflation we saw in 2022 may well cause a major economic collapse of one sort or another. When recession comes, and unemployment starts rising, the markets are expecting the Fed to start lowering interest rates and loosening monetary policy.

For information on what our economic prospects will look like at that point, have a look at my article about Reflation.

Volcker Disinflation

Since the cost of bringing inflation under control is some amount of sacrificed output, probably meaning a recession, the question of how much output needs to be reduced in order to bring about a given reduction in the inflation rate presents itself. 

This has been answered already in my article about the Sacrifice Ratio, but a specific example here may be of use. In particular, the 1980s are of interest, because that was a period of initially very high inflation that was brought under control by the Fed Chairman Paul Volcker.

Prior to Volcker, the research of the day had estimated that the cost of disinflation could be as high as 10 to 1 i.e., that a 1 percentage point reduction in the inflation rate would require as much as a 10 percentage point reduction in the GDP growth rate. However, the experience of the early 1980s under Volcker made a nonsense of that. Lawrence Ball estimates that the real sacrifice ratio at this time was around 1.832.

The peak rate of inflation reached around 15% in 1980, and the Federal Funds Rate of interest went as high as 19% in order to get ahead of it. For most of the 1980s the Federal Funds Rate was maintained at a rate about 4 percentage points higher than the inflation rate and, over the course of the decade, inflation was brought under control to a range of about 2 to 3 percent per year thereafter.

The relatively small cost of disinflation may have been related to the credibility of Paul Volcker and of President Ronald Reagan. Both were firmly committed to the cause of beating inflation once and for all, and they were quite prepared to accept the 1981-1982 recession in order to do it.

Credibility is an important ingredient for achieving policy aims because it affects expectations in the economy. As explained above, expectations alone are highly influential in the cause of inflation or disinflation, and the sacrifice ratio could well have turned out much higher had the Fed Chair and the President been less credible.

There are many other factors that affect the cost of disinflation, and the flexibility of wage rates is one of the most important. For details on that, see my article about sticky wages and prices.

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