Moderate Deflation Is Just an Inflation Rate That Is Too Low

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Monday, 11 March 2013 04:46

Zero holds a bizarre place in policy debates. In the United States we have many policy types who seem to worship a balanced budget. At the start of the last decade there was a modest clamoring on the right for a monetary policy targeting zero inflation. In the same vein we continue to see assertions that deflation would pose some inordinate problem, as though something awful happens when the change in the aggregate price level turns negative.

The culprit today is the NYT, which has an article on the European Central Bank's decision to leave its short-term interest rate unchanged. At one point it told readers that deflation is:

"a broad decline in prices that, by discouraging consumer spending and business investment, can be more economically destructive than runaway inflation."

Actually, a moderate rate of deflation (e.g. less in absolute value than -1.0 percent) would have only a very modest impact in depressing demand. The inflation rate is an aggregate of hundreds of thousands of price changes. When the rate is near zero, many of these price changes are in fact negative. (Some are negative because of imputations of quality improvements by government statistical agencies, as has often occurred with new cars and computers. Actual prices in the market may be increasing.)

The shift from a low positive inflation rate to a low rate of deflation simply means that the price change is negative for a larger share of these items. It is not remotely plausible that this shift can have disastrous economic consequences.

There is a story where falling prices lead to more rapidly falling prices, which would have a devastating impact on the economy, but this acceleration downward is no more likely (and probably less likely) than a sudden acceleration upward. As a practical matter, the economy would benefit from a higher rate of inflation, since that would reduce real interest rates and thereby spur growth. In this sense, a 0.5 percent rate of deflation is worse than a 0.5 percent rate of inflation in the same way that a 0.5 percent rate of inflation is worse than a 1.5 percent rate of inflation. There is no magic to crossing the zero line.