Readers Question: As the cause of inflation to a large part is down to energy costs, if they are temporary, will we see large deflation if we see a return to something close to ‘normal’? Typically deflation would be a bad thing, but in this case would it be?
Firstly, you are correct a large part of current inflation is due to energy costs, and energy prices have a big effect on the inflation rate.
The spike in gas prices in 2022, led to a rise in inflation around the world – especially in Europe who were more affected because they relied on Russian imports
US inflation soared in 2022, due to rising oil and gas prices. As energy prices fell, we saw the inflation rate come down, but the overall price level didn’t fall – it just increased at a slower rate.
Note: Deflation – means a fall in the price level – a negative inflation rate
If energy prices fall, does that cause deflation?
Though energy is very important to inflation, it is not the only factor affecting inflation
- So, even if energy prices fall, we may have residual inflation from other goods and services as the economy re-adjusts to lower energy prices.
- When energy prices rose 40%, this caused inflation of 9%.
- But, workers needed higher wages to compensate for higher costs of living. Therefore, rising wages caused other forms of inflation in the economy.
- So even though oil prices came down, there were also other inflationary pressures in the economy.
Link between oil prices and US inflation
If the fall in energy prices is sufficiently large and the economy quickly catches up to changed inflation expectations (perhaps helped by lower growth) then we could get actual deflation, (like we did briefly in 2009) after the post-recession fall in oil prices.
Deflation is quite rare – there was a small amount of deflation in 2009 – due to falling oil prices and deep recession.
Lower oil prices and slower price increases
The graph of oil prices shows a strong link between oil prices and inflation. But, the important thing is that falling oil prices tends to only reduce the rate of inflation, which means prices rise at a slower rate.
In 2022, the UK price level rose at rapid rate, but the rate of increase slowed down as energy prices fell.
Lower oil/gas may not lead to lower prices
In the UK, household energy prices didn’t fall that much when gas prices fell 80%. This was because, the government subsidised energy prices. Also, there are several factors affecting household electric prices other than cost of natural gas (like network costs). See why energy is expensive in the UK
Would deflation caused by falling energy prices be a good form of deflation?
Basically, yes. Because this deflation represents lower costs and so we get the best of both worlds – lower prices, but also the capacity to have lower business costs and more output.
It can be described by a simple AD/AS diagram.
Lower
Lower energy prices shift SRAS to the right causing lower prices, but also higher real GDP.
Lower energy prices would be like a big increase in disposable income for hardpressed households and could see a rise in spending and saving.
At the moment higher energy prices are causing the worst of both worlds – lower output, higher inflation (stagflation). Falling energy prices would hopefully cause the opposite.
However deflation is always a danger
Having said that there is always a danger that the ‘good’ deflation could easily turn into the ‘bad’ deflation (see: Types of deflation) – especially if lower energy prices are caused by a recession. If prices fall and we get a fall in consumer spending, then all the problems of deflation (higher debt burden, reluctance to spend) could contribute to weaker growth.
For example, in theory, the deflation of 2009 caused by lower oil prices should have been good. But, in practice because it occured during a recession and financial crisis, the problems of deflation probably exacerbated the recession.
Further reading
Originally published 2 June 2022 (during oil price surge) updated 2 January 2026.
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