There has been a bizarre cult of deflation phobia over the last decade in which we are supposed to be terrified that very low positive rates of inflation can decline further and turn into low rates of deflation, which then create really big problems. The NYT tells us this cult is still dominating economic thinking. In an article on the latest data on inflation and unemployment in the euro zone, it noted that European Central Bank President Mario Draghi unexpectedly lowered interest rates in November:
"amid concern that Europe might be headed toward a Japan-style deflationary quagmire."
In reality Europe is already in a Japan-style deflationary quagmire. It suffers from an inflation rate that is too low. A higher inflation rate would translate into lower real interest rates, giving firms more incentive to invest. It would also reduce debt burdens for homeowners as the real value of their mortgage debt fell. It would also allow the peripheral countries like Greece, Spain, and Italy to regain competitiveness, if they held wage and price increases below the rates in Germany and other core countries.
For these reasons the near zero inflation rate is making Europe's problems more difficult, delaying the adjustment process that could allow it to return to a healthy growth path. If the inflation rate were to fall further, say from a positive 0.7 percent to a negative 0.3 percent, this would make matters worse, but only in the same way that a drop in the inflation rate from a positive 1.7 percent to 0.7 percent also makes the situation worse. The issue is a one percentage point decline in the inflation rate, there is no importance to crossing zero.
This should be obvious to people familiar with the construction of price indices. The indexes are based on the collection of millions of different price changes. When the index is near zero, many prices are already falling. Going from a low positive to a low negative rate means that the percentage of falling prices in the index has risen somewhat. How could this possibly have catastrophic consequences for the economy? (In this context it is worth noting that computers and cell phones have had rapidly falling prices for decades. Has everyone noticed the disasters befalling these industries?)
Also, the prices recorded for each item depend on quality adjustments imputed by the statistical agencies. Often the price of a product like a refrigerator or a car might show an increase, but due to imputed quality adjustments it will be recorded as a price decline. Is it plausible that the economy would face some horror story if the pace of quality improvement in these products increases slightly?
The notion that something bad happens if inflation crosses the zero line and becomes deflation is silly on its face. (There is a bad story where the rate of deflation continually accelerates, but even Japan never saw this.) It is often said that economists are not very good at economics. The concerns over a deflation horror story provides a good example of this proposition.
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