The de­fla­tion bo­gey­man

Financial Mirror (Cyprus) - - FRONT PAGE -

The world’s ma­jor cen­tral banks are cur­rently ob­sessed with the goal of rais­ing their na­tional in­fla­tion rates to their com­mon tar­get of about 2% per year. This is true for the United States, where the an­nual in­fla­tion rate was -0.1% over the past 12 months; for the United King­dom, where the most re­cent data show 0.3% price growth; and for the eu­ro­zone, where con­sumer prices fell 0.6%. But is this a real prob­lem?

The sharp decline in en­ergy prices is the pri­mary rea­son for the re­cent drop in the in­fla­tion rate. In the US, the core in­fla­tion rate (which strips out changes in volatile en­ergy and food prices) was 1.6% over the last 12 months. More­over, the US Fed­eral Re­serve, the Bank of Eng­land, and the Euro­pean Cen­tral Bank un­der­stand that even if en­ergy prices do not rise in the com­ing year, a sta­ble price level for oil and other forms of en­ergy will cause the in­fla­tion rate to rise.

In the US, the in­fla­tion rate has also been de­pressed by the rise in the value of the dollar rel­a­tive to the euro and other cur­ren­cies, which has caused im­port prices to decline. This, too, is a “level ef­fect,” im­ply­ing that the in­fla­tion rate will rise once the dollar’s ex­change rate stops ap­pre­ci­at­ing.

But, de­spite this un­der­stand­ing, the ma­jor cen­tral banks con­tinue to main­tain ex­tremely low in­ter­est rates as a way to in­crease de­mand and, with it, the rate of in­fla­tion. They are do­ing this by promis­ing to keep short-term rates low; main­tain­ing large port­fo­lios of pri­vate and gov­ern­ment bonds; and, in Europe and Ja­pan, con­tin­u­ing to en­gage in large-scale as­set pur­chases.

The cen­tral bankers jus­tify their con­cern about low in­fla­tion by ar­gu­ing that a neg­a­tive de­mand shock could shift their economies into a pe­riod of pro­longed de­fla­tion, in which the over­all price level de­clines year af­ter year. That would have two ad­verse ef­fects on ag­gre­gate de­mand and em­ploy­ment. First, the fall­ing price level would raise the real value of the debts that house­holds and firms owe, mak­ing them poorer and re­duc­ing their will­ing­ness to spend. Sec­ond, neg­a­tive in­fla­tion means that real in­ter­est rates rise, be­cause cen­tral banks can­not lower the nom­i­nal in­ter­est rate be­low zero. Higher real in­ter­est rates, in turn, de­press busi­ness in­vest­ment and res­i­den­tial con­struc­tion.

In the­ory, by de­press­ing ag­gre­gate de­mand, the com­bi­na­tion of in­creased real debt and higher real in­ter­est rates could lead to fur­ther price de­clines, lead­ing to even larger neg­a­tive in­fla­tion rates. As a re­sult, the real in­ter­est rate would rise fur­ther, push­ing the econ­omy deeper into a down­ward spi­ral of fall­ing prices and de­clin­ing de­mand.

For­tu­nately, we have rel­a­tively lit­tle ex­pe­ri­ence with de­fla­tion to test the down­ward-spi­ral the­ory. The most widely cited ex­am­ple of a de­fla­tion­ary econ­omy is Ja­pan. But Ja­pan has ex­pe­ri­enced a low rate of in­fla­tion and some sus­tained short pe­ri­ods of de­fla­tion with­out ever pro­duc­ing a down­ward price spi­ral. Ja­pan’s in­fla­tion rate fell from nearly 8% in 1980 to zero in 1987. It then stayed above zero un­til 1995, af­ter which it re­mained low but above zero un­til 1999, and then var­ied be­tween zero and -1.7% un­til 2012.

More­over, low in­fla­tion and pe­ri­ods of de­fla­tion did not pre­vent real in­comes from ris­ing in Ja­pan. From 1999 to 2013, real per capita GDP rose at an an­nual rate of about 1% (which re­flected a more mod­est rise of real GDP and an ac­tual decline in pop­u­la­tion).

Why, then, are so many cen­tral bankers so wor­ried about low in­fla­tion rates?

One pos­si­ble ex­pla­na­tion is that they are con­cerned about the loss of cred­i­bil­ity im­plied by set­ting an in­fla­tion tar­get of 2% and then fail­ing to come close to it year af­ter year. An­other pos­si­bil­ity is that the world’s ma­jor cen­tral banks are ac­tu­ally more con­cerned about real growth and em­ploy­ment, and are us­ing low in­fla­tion rates as an ex­cuse to main­tain ex­cep­tion­ally gen­er­ous mon­e­tary con­di­tions. And yet a third ex­pla­na­tion is that cen­tral bankers want to keep in­ter­est rates low in or­der to re­duce the bud­get cost of large gov­ern­ment debts.

None of this might mat­ter were it not for the fact that ex­tremely low in­ter­est rates have fu­eled in­creased risk-tak­ing by bor­row­ers and yield-hun­gry lenders. The re­sult has been a mas­sive mis­pric­ing of fi­nan­cial as­sets. And that has cre­ated a grow­ing risk of se­ri­ous ad­verse ef­fects on the real econ­omy when mon­e­tary pol­icy nor­malises and as­set prices cor­rect.

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