What Is Reflation?

Definition and Example of Reflation

Reflation occurs when consumer prices rise when the economy is below full employment and growth. Full employment is the level of employment the economy produces at its maximum potential output, and no workers are involuntarily unemployed. An economy is below full employment during a recession or a cyclical downturn in the economy. In response to lower demand for goods and services in a recession, the central bank or government may stimulate the economy, which leads to prices rising and reflation.

In economic terms, reflation refers to inflation rising from a below-average level back toward its long-term trend. Both reflation and inflation refer to an increase in price levels. However, an important distinction between the two is the period in which the price increase occurs.

One example of reflation happened during the Great Recession of 2007-2009. The Federal Reserve increased bond buying and bought other assets such as mortgage-backed securities to spur economic activity and increase the U.S. money supply.

Congress also enacted multiple economic spending programs, such as the Troubled Asset Relief Program (TARP), to add capital to banks to encourage them to continue lending money. While these programs slowly increased prices and economic activity, it was considered to be a period of reflation, as the economy was not at full employment until December 2017.

Another way to think about reflation is to consider a balloon that has lost its air. The balloon has the potential to be quite large but needs some help to get back to its normal shape. Reflation would be the byproduct of blowing up the balloon to its normal shape.

How Does Reflation Work?

Reflation typically occurs during a recession, when central banks and governments provide stimulus to spur economic activity. A central bank, such as the Federal Reserve, can conduct monetary stimulus to spur economic activity.

For example, the Federal Reserve could lower interest rates and buy bonds to expand the money supply. It also can introduce programs such as directly lending to small and midsized non-financial businesses.

All of these monetary policy actions would increase the amount of money available to banks to lend to businesses and consumers. This, in turn, can boost demand and increase the number of people working, which would bring the economy closer to full employment.

Congress also can conduct fiscal stimulus to spur economic activity by providing funds to small businesses or direct payments to households to increase the money available in the economy.

Notable Happenings

The Federal Reserve bought bonds from 2020 through most of 2021 to inject the economy with money and assist the financial sector. It also has directly lent money to non-financial businesses and state governments and relaxed bank regulatory requirements. In addition, Congress has directed payments to individuals, extended unemployment benefits, and lent money to local governments. Together, these actions have caused reflation while lifting the economy back toward full employment.

The unemployment rate in January 2020 was 3.5% but reached a peak of 14.8% in April 2020. Since then, it has fallen to 3.6% as of March 2022. An unemployment rate of 4% to 6% used to be considered the full employment level, but recently, the Fed’s Board of Governors has chosen not to define full employment as a numerical estimate. Instead, it is based on a range of relevant indicators.

One of these indicators involves comparing the unemployment rate prior to a recession and after. When the U.S. economy moves to, or close to, the pre-recession level of unemployment or the full-employment level, the country is most likely no longer in a period of reflation.

In 2021 and early 2022, persistent COVID-19 Delta and Omicron variants resulted in business shutdowns causing global supply chain issues. As a result, inflation increased dramatically, meaning prices rose while at or near full employment. For example, inflation year-over-year in March 2022 was 8.5%, which is significantly higher than the normal 1% to 2% inflation rate for the United States.

The previous easy monetary policy by the Federal Reserve needed to be reversed to tighten monetary conditions by increasing interest rates and halting the Fed's bond purchase program. These actions are designed to bring down inflation and bolster business investment and consumer spending.