Disinflation

Disinflation is a fall in the rate of inflation: prices are still rising, but more slowly than before. If annual inflation drops from 8% to 3%, the economy has experienced disinflation, even though the price level is higher at the end than at the start. The term is used by central banks, finance ministries and market analysts to describe the path of inflation back toward a target after a surge.

Disinflation is different from deflation, which is an outright fall in the general price level. It is usually measured with the annual change in the Consumer Price Index (CPI) or a "core" measure that strips out food and energy. Deliberate disinflation is a central task of monetary policy, and its cost in lost output and jobs is one of the most studied questions in macroeconomics.

Think of a car that has been speeding up. Disinflation is the driver easing off the accelerator: the car is still moving forward, just gaining speed more slowly. Deflation would be the car actually going backwards.

So when a news report says "inflation fell to 3%", prices have not fallen. A basket of groceries that cost 100 a year ago now costs 103 instead of the 108 it might have cost during the peak. Shoppers often find this confusing because the bills in their hands are still higher than they used to be. Disinflation means the climb has become gentler, not that the climb has been undone.

Inflation can slow for several reasons, often at the same time:

• Tighter monetary policy. Higher policy rates raise borrowing costs, cool demand for houses, cars and investment, and strengthen the currency, which makes imports cheaper. Central banks may also shrink their balance sheets through quantitative tightening (QT).
• Fading supply shocks. When an earlier supply shock, such as an oil-price spike or blocked shipping routes, unwinds, the prices that jumped stop rising or fall back.
• Tighter fiscal policy. Lower government spending or higher taxes reduce aggregate demand.
• Anchored expectations. If workers and firms believe the central bank will bring inflation down, they moderate wage and price demands, which helps break a wage-price spiral.

Economists measure the cost of disinflation with the sacrifice ratio, the cumulative loss of output for each percentage point of inflation removed:

• The output loss is the sum of the yearly gaps between actual and potential gross domestic product (GDP) during the episode, as measured by the output gap.
• The fall in trend inflation is the drop in underlying inflation from the start to the end of the episode.

Worked example: if inflation falls from 9% to 3% (6 points) and output runs 2% below potential for three years (a total loss of 6% of GDP), the sacrifice ratio is $6 \div 6 = 1$: each point of disinflation cost about 1% of a year's output. Estimates vary widely between countries and periods. The ratio tends to be lower when the central bank is credible and when rational expectations lead people to adjust quickly, and higher when wages and prices are set in long contracts or are sticky.

The best-known case is the Volcker disinflation in the United States. After Paul Volcker became chair of the Federal Reserve in 1979, the Fed tightened sharply; US consumer price inflation fell from about 13.5% in 1980 to around 3% by 1983, at the cost of two recessions and unemployment above 10% in late 1982. The episode shaped the later consensus on central-bank independence and the Great Moderation that followed.

A second example is the post-pandemic period. US CPI inflation peaked at 9.1% in June 2022 and fell to around 3% within about a year, while unemployment stayed low. Several economists described this as an unusually painless disinflation and attributed much of it to the unwinding of supply-chain and energy shocks plus expectations that stayed close to target. Similar declines occurred in the euro area and the United Kingdom, where inflation had peaked above 10% in late 2022.

Emerging markets offer further cases. Brazil's Real Plan of 1994 brought down very high inflation, and India's move to formal inflation targeting in 2016 was followed by lower average inflation than in the preceding decade.

Disinflation often slows as inflation gets close to target, a stage commentators call the "last mile". Services prices, which are labour-intensive and tied to wages, tend to cool more slowly than goods prices. The trade-off between inflation and unemployment that policymakers face during this stage is described by the Phillips curve; when it is flat, bringing inflation down the final stretch can require a larger rise in unemployment. Central banks also watch for overshooting: tightening too long can turn disinflation into a recession, which is why policy rates are usually cut before inflation reaches target, given the lags with which policy works.

• Federal Reserve: Monetary Policy
• International Monetary Fund: World Economic Outlook