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Euro Zone Already Suffers from Dreaded Low Inflation

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Tuesday, 03 June 2014 20:05

The NYT persists in pushing the bizarre notion that something horrible happens to economies when the inflation rate crosses zero and turns negative. Today it gave us an article with the headline of an article, "Euro Zone Edges Closer to Dreaded Deflation."

The story is that inflation in the year ending in May was just 0.5 percent, as compared to 0.7 percent for the year ending in April. It tells readers:

"Many economists say that inflation is already well below the danger zone for tipping into deflation, and some analysts have taken to calling the condition 'lowflation.'

 

 

Come on folks, this makes zero sense. Borrowers face higher real interest rates any time the inflation rate falls. If borrowers had negotiated mortgages anticipating a 2.0 percent inflation rate, then the drop to 1.0 percent means that the real burden of the mortgage is larger than expected. If the inflation rate falls to zero then the real burden of the mortgage is even larger. If it becomes negative so that prices are falling at the rate of 1.0 percent a year the situation is even worse. But the drop from zero to -1.0 percent is not different from the drop from 1.0 percent to 0.0 percent, or 2.0 percent to 1.0 percent. Each increases the burden on debtors.

A basic understanding of the inflation rate should make this point clear. It is an aggregate of millions of different price changes. When the aggregate rate is near zero the prices of many items are already falling. Crossing zero would just mean that the percentage of items with falling prices has increased. How could that possibly be of great consequence for the economy?

The prices in the index are also quality adjusted price. This often lead to situations in which the quality adjusted price shows declines even if the actual price of the product increased. There have been several months in the last few years in which the quality adjusted price of cars showed a decline. I doubt there were any months in which new car prices actually fell. Are we supposed to believe that something awful happens in the economy if the statistical agency finds that products are improving at a more rapid rate and therefore quality adjusted prices are now falling?

Even the idea that the year over year measure provides some vital statistic is silly on its face. Suppose prices fell at 0.6 percent rate in both June and July of 2013 and have risen at a 0.1 percent rate in the subsequent 10 months. (We'll assume that they rose by 0.5 percent in May of 2013 so the year over year inflation rate had not previously been negative.) Does something bad now happen that we have a 12 month period in which the change in prices was negative?

This really is not hard. The problem is lower than desired inflation, end of story. Whether or not the inflation rate actually turns negative and becomes deflation means zero.

 

Note: Dates corrected, thanks folks.

Comments (11)Add Comment
The allure of 0
written by Squeezed Turnip, June 04, 2014 3:40
the NYT should earn 0¢ for making zero sense on this one.
...
written by lbou, June 04, 2014 5:28
I nod my head when you talk about the implication for debt and the impact of lower than expected inflation. But if we believe that wages are sticky downwards (do we believe that?) Then there might be implications of low inflation vs deflation. With low inflation I can still get a wage increase every year. But with deflation I may not be willing to see my nominal wage fall. Money illusion.
...
written by JSeydl, June 04, 2014 5:36
latest inflation number is for May, not April.
Relative
written by Ryan, June 04, 2014 5:55
The importance of a reference point and relative change is the key, it's not about the absolute rate of price change. I would love to see them explain relativity. There, at least rhey would not feel the need to opine, they would say instead "hey, we're not scientists man."
Low Inflation
written by jbakho, June 04, 2014 6:46
For the exact reasons stated above, a Fed target inflation rate can be too low. Pressure on wages to deflate causes unemployment because wages are sticky downward.
Inflation is necessary to allow relative prices to reset upward. Inflation needs to be high enough that wages constantly inflate at a reasonable rate. Downward pressure on wages is one reason why and inflation target of 2 percent is unreasonable.
Yellen
written by Peter K., June 04, 2014 8:42
Didn't Yellen convince Greenspan to go with a positive long-run inflation target for the reasons jbakho states above?

Yes, here's a helpful link from Mr. Baker from last year:

http://www.cepr.net/index.php/blogs/beat-the-press/did-janet-yellen-argue-with-greenspan-for-higher-or-lower-interest-rates
great quote
written by benjamin, June 04, 2014 9:12
Even with that deep discounting, “sales are still low,” he said, “because people don’t have money.”

put this man in charge.
PARAGRAPH ERROR
written by atlga, June 04, 2014 4:33
The second paragraph in your article is wrong. It's showing two different statistical numbers for the same time frame period, the NYT article says: "Inflation in the 18 nations that share the euro rose at an annual rate of just 0.5 percent in May from a year earlier, down from a 0.7 percent in April..."
PARAGRAPH ERROR CORRECTED
written by atlga, June 04, 2014 5:10
I'm glad to see CEPR corrected the error in its article.
...
written by atlga, June 04, 2014 5:28
You're welcome.
Where is the Beef?
written by Larry Signor, June 04, 2014 9:00
If we applied as critical an eye towards the media as commentators apply to Dean, we would not need Beat the Press. Perhaps we should indulge in less critical minutiae of our bretheran and cast a more critical eye on our detractors. Just thinkin'.

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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.

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