Disinflation Explained: A Slower Inflation Rate – Causes, Impacts and Examples

What’s it: Disinflation is a situation in which the price level increases at a slower rate of growth. In other words, inflation is still positive but lower than the previous period. For example, suppose the inflation rate slowed from 3% inflation in the second quarter to 2.5% in the second quarter and 2.1% in the third quarter.

If the percentage falls into negative territory, it is deflation. For example, the inflation rate would be -0.1% in the second quarter and -0.2% in the third quarter. In general, deflation is more dangerous than deflation.

Disinflation vs. Deflation

Disinflation is a common phenomenon in an economy. It may happen during a phase of a weak economy where demand starts to slow down.

Businesses might respond by offering slight price cuts or smaller price increases to maintain sales volume. Consumers, feeling a pinch on their wallets, might become more budget-conscious, leading to a natural moderation in overall price hikes.

Conversely, deflation is a more dangerous phenomenon. A fall in the price level usually occurs during a severe economic downturn, such as a recession or depression. At that time, demand plummeted because most households were forced to be thrifty.

High unemployment rates make income prospects worse, leading to a vicious cycle where people have less money to spend, further weakening demand and causing businesses to slash prices in a desperate attempt to attract customers.

Indeed, during deflation, the purchasing power of money increases on paper. However, this doesn’t translate to increased spending because people are likely worried about job security and holding onto their cash. They might even delay essential purchases in the hope of even lower prices in the future. This further weakens economic activity and can trap the economy in a deflationary spiral.

Also, deflation causes real debt to increase. It hurts borrowers because the value of their debt remains the same, but the value of the money they use to repay it increases. This makes it harder to pay off loans, discourages borrowing for investment, and hinders economic growth. This phenomenon, where the burden of debt becomes heavier due to deflation, is referred to as debt deflation.

Measuring disinflation

Like inflation, we measure disinflation using a price index. The most quoted indicator is the consumer price index (CPI). An alternative is the producer price index or GDP deflator.

CPI inflation measures changes in the average price of consumer goods and services. It is one of the most monitored measures of the economy by investors and central banks. The company also monitors it, especially to adjust cost components (such as salaries) and its selling prices.

The percentage change in the CPI over time refers to the inflation rate. We can calculate it with the following formula:

• Inflation rate = [(CPI_t / CPI_t-1) -1] * 100%

I have applied the above formula to calculate the inflation rate. The results are as follows:

The table shows that there was deflation between 2011 and 2012, with the inflation rate falling from 4.0% to 2.0% and then to 1.0%.

Furthermore, in 2016-2018, the economy experienced deflation because the inflation rate moved into negative territory.

Causes of disinflation

Disinflation, a slowdown in inflation, can arise from several key factors:

Central banks taking control: tighter monetary policy

Central banks play a critical role in managing inflation. When inflation rises above comfortable levels, they might implement a tighter monetary policy to cool down the economy and slow down price increases. Here’s how they achieve this:

• Raising interest rates: Higher interest rates make borrowing more expensive for businesses and consumers. This discourages excessive borrowing and spending, ultimately leading to slower price growth.
• Increasing reserve requirements: Central banks can also require banks to hold a higher percentage of their deposits as reserves. This reduces the amount of money available for lending in the economy, potentially dampening inflation.
• Open market operations: By selling government bonds in the open market, central banks can reduce the money supply in circulation, which can contribute to disinflationary pressures.

Slowing economic growth and weakening demand

Disinflation can also occur when the overall economy experiences a slowdown in real GDP growth. This can happen due to various factors, but it ultimately leads to weaker aggregate demand, the total demand for goods and services in the economy.

• Consumers tighten their belts: As economic growth slows, consumers might become more cautious with their spending. This reduced demand can lead businesses to hold back on raising prices or even offer slight discounts to maintain sales volume.
• Businesses adjust production and pricing: When demand softens, businesses might need to adjust their production rates to avoid excess inventory. This can lead to a situation where supply outpaces demand, putting downward pressure on prices.

Disinflation vs. Recession: a delicate balance

Disinflation can occur at the beginning of a recession, but it’s important to distinguish it from deflation, a more severe phenomenon. During a recession, economic activity contracts, and economic indicators like GDP growth turn negative. However, disinflation might still be observed in this early stage, as businesses might be hesitant to raise prices due to weakening demand. But there’s a fine line here.

If the recession deepens, businesses may be forced to slash prices further to clear out excess inventory and stay afloat. Consumers, facing job insecurity and declining incomes, may also become more frugal, further dampening demand. This downward spiral in prices can lead to deflation, a sustained decline in the overall price level, which can be much more damaging to the economy than disinflation.

The money supply equation to explain

Economists use the quantity theory of money to understand the relationship between the money supply, inflation, and economic activity. This equation is expressed as:

• M x V = P x Y

Where:

• M = Money Supply
• V = Velocity of Money (how often money changes hands)
• P = Price Level
• Y = Real Output (total goods and services produced)

In simpler terms, this equation suggests that a change in the money supply (M) or the velocity of money (V) can influence the price level (P) or the real output (Y) of the economy. Disinflation can occur if the money supply grows at a slower pace than economic output (Y).

Impacts of disinflation

Disinflation, unlike deflation, is generally considered a benign phenomenon within the economic cycle. Here’s how it can impact different stakeholders:

Consumer: Disinflation benefits consumers by increasing their purchasing power. As the rate of inflation slows down, the value of their money stretches further. Imagine inflation falls from 5% to 3% while your salary increases by 4%. 

In the first scenario (5% inflation), your raise wouldn’t fully offset rising prices. But with disinflation (3% inflation), your salary increase outpaces inflation, allowing you to buy more goods and services.

Businesses: While disinflation can improve consumer purchasing power, it can also lead to slower revenue growth for businesses, especially if they maintain fixed sales volume.

If a company previously raised prices by 3% to keep up with inflation, they might have to settle for a smaller increase (perhaps 1%) in a disinflationary environment to avoid losing customers to competitors. This can squeeze profit margins, forcing businesses to innovate and find efficiencies to maintain profitability. In some cases, disinflation might even lead to price wars as businesses compete aggressively on price to attract customers with tighter budgets.