Definition of disinflation
What is disinflation?
Disinflation is a decrease in the inflation rate over a given period of time. It should not be confused with deflation which is a general decrease in prices. During periods of disinflation, prices continue to rise, but at a slower pace than in the previous period. The inflation rate remains positive. Households continue to lose purchasing power.
If in France, for example, the inflation rate went from 2% in January to 1.5% in February, we say that there is disinflation.
Competitive disinflation policy
A competitive disinflation policy can be implemented by the central bank in the event that inflation reaches too high a level. In times of economic expansion, economic growth is very often accompanied by a gradual increase in inflation. This inflation is self-sustaining. Effectively, as wages are indexed (directly or indirectly) to the inflation rate, the higher the prices, the higher the wages. To compensate for the increase in wages, companies increase their prices, which generates additional inflation.
To avoid overheating the economy, the central bank may therefore decide to apply a competitive disinflation policy. The objective is then to limit access to credit and reduce the growth in the money supply. To do this, the central bank has a very effective tool at its disposal, interest rates. By raising its key rates, the inflation rate will initially stabilize before gradually decreasing (in theory). If the inflation rate falls but remains positive, then we enter a period of disinflation.
Consequences of disinflation
The implementation of a competitive disinflation policy is beneficial in the short term for economic agents. For households, it is a way to slow the decline in their purchasing power, as the price of goods and services increases more slowly.
For companies, disinflation makes it possible to stop wage increases that affect their price competitiveness. Effectively, to compensate for the increase in wages, companies increase their prices to keep their profits. For French companies, this is no problem. On the other hand, for companies exporting goods and services, this price increase undermines their competitiveness. They may then either decide to cut back on their margins or risk losing market share by increasing their prices.
Disinflation solves this dilemma. It therefore has positive short-term effects for all economic agents. In the longer term, the consequences of disinflation are much worse. Effectively, these higher interest rates to fight inflation have the effect of slowing down economic activity. Households consume less because the cost of credit is higher. Faced with declining consumption, companies reduce their investments, fuelling the economic slowdown. In the long run, a competitive disinflation policy can therefore lead to an economic recession and deflation.