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Silliness About the Risks of Deflation

Tuesday, 10 August 2010 05:05

Reporters continually discuss deflation as though something magical will happen if the rate of price growth crosses zero, and turns negative. This is silly. The point is that a lower rate of inflation raises real interest rates at a time when we want lower real interest rates. We can't lower nominal rates below zero, so any decline in the inflation rate right now is bad news.

In this sense, 0.5 percent inflation is worse than 1.5 percent inflation. The situation gets still worse if this goes to a negative inflation rate of -0.5 percent. But the drop from 0.5 percent to -0.5 percent is no worse than the drop from 1.5 percent to 0.5 percent.

This is important to understand because the fixation on deflation implies that somehow everything is okay as long as our inflation rate is still positive. That is not true: the economy is suffering from an enormous output gap leading to tens of millions of people needlessly facing unemployment or underemployment.

Comments (11)Add Comment
written by izzatzo, August 10, 2010 6:09
This is important to understand because the fixation on deflation implies that somehow everything is okay as long as our inflation rate is still positive.

There's a fairly bright line between those who understand this or not, but a much brighter line between those or not who don't understand deflation at all, the one-directional nots claiming the sky will fall from future inflation.

Then there's those who claim to understand it, asserting that where deflation could turn things around via reductions in real relative prices and corresponding increases in real income, it can't due to government interference in trying to suppress deflation.
Is this the beginning of the deflationary death spiral?
written by Scott ffolliott, August 10, 2010 7:54
Is this the beginning of the deflationary death spiral?
written by Mark G., August 10, 2010 10:51
Inflation isn't going to fix an imagined "output gap". Thirty years of pulling demand forward via massive increases in public/private debt has ended. There is no output gap. The end of a multi-decade credit bubble makes economists talk about an output gap. Economists are always the last to understand
If one lends money to those engaged in a criminal activity, can one legally expect this debt to be repaid?
written by Scott ffolliott, August 10, 2010 10:58
If one lends money to those engaged in a criminal activity, can one legally expect this debt to be repaid?
Wage and Price Deflation in a Consumer Driven Economy
written by Ron Alley, August 10, 2010 1:38
Crossing the zero inflation threshold is not a big deal, but in our consumer driven economy crossing the threshold of nominal, healthy inflation (perhaps about 2%) is a big deal indeed. In order for the the economy to grow, the supply of money in the hands of consumers willing to spend must be sufficient to stimulate domestic production and domestic employment. With a small rate of inflation, That is what I consider nominal, healthy inflation.

In addition, I believe that inflation should be balanced. By that I mean that the inflation of prices and that wages should be approximately equal.

For the last twenty five years or so, price inflation has remained at a nominal healthy level. However, wages have not kept pace with prices.

Since about 2002, real wages have declined. We crossed the zero threshold on wage inflation long ago. For a while, consumers used credit and the real estate bubble to continue purchasing goods to sustain a life style that they could not support through wage growth. With the bursting of the housing bubble and the big recession, consumers found they could no longer resort to credit to maintain their life style. Demand has dropped. Employment has dropped. At this point we have between 15 and 20 percent of the workforce either unemployed or underemployed. So, I don't expect to see demand increase in the near future.

I believe that the economy will not improve significantly until the federal government realizes that the tools used by the Federal Reserve and stimulus spending are not sufficient to correct the underlying problem.

While actions of the federal government (including the Federal Reserve) may have been modest, the results have been less than expected. In my view, the underlying problem is a set of federal policies, domestic and international, that systematically favored corporate interests over the interests of workers and consumers. No amount of stimulus or increase in the money supply will create domestic jobs if the goods and services being purchased are produced outside the United States. Until we review and correct a regulatory regime that favors offshore production, corporations will continue to export the production of goods and services.
written by OJC, August 10, 2010 4:05
Can someone explain to me how a lower rate of inflation leads to higher interest rates? It would appear that high inflation should lead to a lower value of the repaid money, hence higher interest to compensate.
written by purple, August 10, 2010 4:40
Hi Help,

You raise a point, but this is seldom how it works in the real world. Banking interests hate inflation, we see that most obviously with Trichet and the ECB. Keep in mind not all capital is lent out which means capital reserves are smoked during periods of inflation.
Real vs Nominal
written by AndrewS, August 10, 2010 6:24

You are missing the distinction between real and nominal interest rates. The real interest is the difference between the nominal rate of interest less the rate of inflation.

Think of getting a raise. You get 20% one year, pretty good huh? Well if that year inflation is 19% you have a real wage increase of only 1%. You'd be better off getting a 3% raise with zero inflation.

So as you say, if inflation runs high you may see a rise in nominal interest rates, but the real rate is what you need to consider and real rates are what Dean is talking about here.
written by skeptonomist, August 10, 2010 10:01
There is also nothing magical about a zero nominal interest rate. If the Fed continued to buy Treasuries so that federal funds went negative and/or set the discount rate negative, it would basically be giving money away to banks and crowding out private investment, but these are things which it is already doing when it forces interest rates down even when the interest rate is still positive. In bad times Keynesians consider it necessary for government to partially take over investment from the private sector, but whether giving money away through banks is the best way to do it is another question.
written by mmckinl, August 11, 2010 5:21
It is called "cash flow". A rate of inflation below 0% implies a deep contraction and with fractional reserve banking that means credit, money supply and velocity are decreasing ... causing a vicious vortex of collapsing demand due to insolvency.
written by scott, August 12, 2010 6:47
Where are prices falling? Lunch costs much more than it did a few years ago, gas, oil, insurance, city/county fees, fines and other regressive taxation is rising. I understand you "elites" miss all of this, but a rich man couldn't afford the expenses the poor pay for the same services.

Yes, if you are well off, desperate poor people are willing to work for anything, this hasn't lowered prices in those "too volatile" markets that comprise the bulk of essential expenses. You silly, detached, ignorant and insulated professionals miss all of this; you specifically exclude these items from measurement.

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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.