Deflation

Deflation is a sustained fall in the general level of prices, not merely slower price increases. A decline in the inflation rate is called disinflation: if inflation remains positive, the general price level continues to rise, but more slowly. The essential distinction is between falling prices and a falling rate of price increase.

Price level versus inflation rate

The inflation rate measures the percentage change in a price index over a specified period. Its direction of movement must therefore be distinguished from whether it is positive or negative.

• If annual inflation falls from 10% to 5%, prices are still increasing. For example, a price index could rise from 100 to 110 and then to 115.5.
• If a price index falls from 100 to 98 over a year, annual inflation is -2%, indicating a decline in the measured price level.
• At zero inflation, the measured price level is unchanged over the comparison period; earlier price increases have not been reversed.

How to identify deflation

Deflation concerns a broad and sustained decline in prices. A fall in the price of one commodity, such as vegetables or crude oil, does not by itself establish economy-wide deflation.

• A broad price index such as the Consumer Price Index helps distinguish general price movements from changes in individual prices.
• A single negative inflation reading requires caution: the index used, the comparison period and the persistence of the decline all matter.
• Different price indices cover different baskets, so a decline in one index need not imply that all measures of prices are falling.

Why the distinction matters for policy

Disinflation can bring excessive inflation under control without requiring an outright fall in prices. Persistent, demand-driven deflation can instead reinforce economic weakness.

• If people expect prices to fall further, they may postpone some purchases, weakening aggregate demand.
• Falling prices increase the real burden of existing nominal debt, making repayment harder for borrowers whose incomes also weaken.
• For a given nominal interest rate, lower expected inflation raises the real interest rate, potentially discouraging borrowing and investment.
• The cause matters: productivity improvements can lower prices while expanding output, whereas deficient demand can lower both prices and output.