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

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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.)