CEPR - Center for Economic and Policy Research

Multimedia

En Español

Em Português

Other Languages

Home Publications Blogs Beat the Press Deflation is a Problem of an Inflation Rate That is Too Low

Deflation is a Problem of an Inflation Rate That is Too Low

Print
Wednesday, 08 January 2014 05:31

When someone touts the risks of deflation it is simply their way of saying that they don't understand the economy. The NYT provided us this service in an article on how the euro zone is seeing a lower than desired rate of inflation.

After noting that year over year inflation was just 0.8 percent in the most recent data, well below the European Central Bank's 2.0 percent target, the article tells readers:

"Europe could face outright deflation — a debilitating economic condition in which prices actually decline across the board.

"As long as hints of deflation remain, the E.C.B. faces a difficult challenge."

It later adds:

"Spain’s consumer prices rose just 0.3 percent, while Italy’s rose only 0.2 percent, as those two countries’ troubled economies teetered near a deflationary cliff.

"Deflation would only add to the broader economic malaise in the region, by hurting corporate profits and by leading consumers to delay purchases in anticipation of better deals in the future. It would also weigh heavily on borrowers, making loan repayments more expensive in real terms — a particular danger for Europe’s already fragile financial sector."

Okay, let's get this straight. It's okay if the inflation rate is 0.2 percent or 0.3 percent, but all hell breaks loose if we are looking at 0.5 percent deflation? How does that work?

The article tells us corporate profits will be lower. Well, ignoring the fact that corporate profits are currently very high, how does a dip from 0.3 percent inflation to 0.5 percent deflation affect corporate profits in a way that is different from a dip from 1.1 percent inflation to 0.3 percent inflation? If the inflation rate is lower than what businesses had expected then they will be selling their output for a lower than expected price. That means lower profits regardless of whether or not the lower inflation rate is positive to negative.

As far as consumers delaying purchases, let's try some arithmetic. Suppose someone is considering a big ticket item like a television or a refrigerator that costs $1,000. If the rate of deflation is 0.5 percent, our would-be buyer would save $2.50 by delaying their purchase for six months. They would get a $5 windfall if they delay the purchase a full year. Is this going to be a big problem?

To make matters worse for the deflation hawks, many prices are already falling even before we fall off the "deflationary cliff." The overall inflation rate is an average of millions of price changes. When the average is positive but close to zero then it is inevitable that the price of many items is already falling. Is that a big problem? Well, the price of computers has been falling sharply for decades.

The real issue here is simple. It would be desirable to have a lower real interest rate in the euro zone to boost demand. This can only be brought about with a higher rate of inflation. It would also be helpful to have higher inflation in core countries like Germany so that peripheral countries like Spain and Greece can regain competitiveness within the euro zone. Going from a positive rate of inflation to deflation is a move in the wrong direction, but it is not qualitatively different from a drop in the rate of inflation to a still positive rate. The problem is simply too low a rate of inflation, there is nothing magical about crossing zero. (As a practical matter, there is enough measurement error in price indices that a low reported positive rate is in fact consistent with a true negative rate.)

Comments (8)Add Comment
Killing the Monster of Price Uncertainty
written by Last Mover, January 08, 2014 7:54
The article tells us corporate profits will be lower. Well, ignoring the fact that corporate profits are currently very high, how does a dip from 0.3 percent inflation to 0.5 percent deflation affect corporate profits in a way that is different from a dip from 1.1 percent inflation to 0.3 percent inflation? If the inflation rate is lower than what businesses had expected then they will be selling their output for a lower than expected price. That means lower profits regardless of whether or not the lower inflation rate is positive to negative.


This is equivalent to an admission that using targeted positive inflation rates to stimulate an economy to full employment with government spending would also benefit business with higher profit for current production.

The primary counteracting force is business that profits on debt held for which the value of payback falls with inflation. It's obvious this side wins hands down to kill any notion of creating intentional inflation, at least enough to reduce unemployment to create a full employment economy.

Talk about debt dragging down the economy - private debt that is. The sock puppets are confused because the real message from their sponsors is to walk the straight and narrow path of no inflation or deflation at all, to mimic "true" real prices.

This is the "certainty" demanded by economic predators behind the curtain, the same "certainty" they get at the micro level by destroying legitimate risk faced by them in legitimate free market competition ... as they preach it to everyone else.

Let nominal prices be steady and stable all around they say, to reflect "true" underlying "real" prices, so markets can be free from the monster of "uncertainty".

Never mind the underlying values prices actually represent these days ... that prevent them from allocating resources to their highest valued use.
So
written by Joe, January 08, 2014 11:47
So I'll get to my destination only slightly slower if I take one step a minute backwards rather than one step a minute forwards?

You're probably correct here, but I think you could come up with more solid reasoning
...
written by JSeydl, January 08, 2014 12:09
Funnily enough, even central bankers don't understand the non-difference between deflation and low inflation. Here's Greenspan:

"Look, we were and we still are pilloried for lowering the federal funds rate in 2003. What I was doing was saying, “What is the probability of deflation?” I would say that the probability was probably 20%. But what is the consequence should it happen? And I’d say horrendous."

http://blogs.hbr.org/2014/01/what-alan-greenspan-has-learned-since-2008/
Economists Disagree
written by Richard Genz, January 08, 2014 1:42
Baker: "When someone touts the risks of deflation it is simply their way of saying that they don't understand the economy."

Ben Bernanke, 2002:

"Sustained deflation can be highly destructive to a modern economy and should be strongly resisted."

http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/
Too low inflation and expectations of even lower inflation
written by Lord, January 08, 2014 3:09
And there is a magical lower limit, that of productivity. Once deflation exceeds this the descent begins.
...
written by Joe, January 08, 2014 3:47
"When someone touts the risks of deflation it is simply their way of saying that they don't understand the economy."

So are you saying deflation isn't something to be avoided? You may want to read some Keen...

A bigger giveaway about someone's economic ignorance would be something like "When someone touts the risks of government debt and deficits, it's simply their way of saying that they don't understand the economy."
...
written by Jay, January 08, 2014 7:27
If price cuts are so bad, then why don't low ball salaries get more news.
...
written by Jesse Maurais, January 11, 2014 10:37
I could be wrong (I'm not an economist) but wouldn't deflation impact people's spending behaviour? If I have some amount of uninvested cash then inflation at any level eats away at its real value, giving me an incentive to spend now rather than latter. On the other hand, if the currency is deflating, the spending power of that money increases the longer I sit on it, giving me an incentive to not spend, which should have a negative impact on aggregate demand if enough people do the same thing. No?

Write comment

(Only one link allowed per comment)

This content has been locked. You can no longer post any comments.

busy
 

CEPR.net
Support this blog, donate
Combined Federal Campaign #79613

About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

Archives