The perils of falling inflation

The perils of falling inflation

In both America and Europe central bankers should be pushing prices upwards

Nov 9th 2013 |From the print edition

WHAT is a central banker’s main job? Ask the man on the street and the chances are he will say something like “keeping a lid on inflation”. In popular perception, and in their own minds, central bankers are the technicians who squeezed high inflation out of the rich world’s economies in the 1980s; whose credibility is based on keeping it down; and who must therefore always be on guard lest prices start to soar. Yet this view is dangerously outdated. The biggest problem facing the rich world’s central banks today is that inflation is too low.The average inflation rate in the mostly rich-world OECD is 1.5%, down from 2.2% in 2012 and well below central banks’ official targets (typically 2% or just under). The drop is most perilous in the euro area: annual consumer-price inflation was only 0.7% in October, down from 2.5% a year ago. That is partly because commodity prices have been falling, but even if you strip out volatile food and fuel prices, the euro zone’s underlying or “core” inflation is 0.8%, as low as it has ever been since the single currency began. In America the headline rate in September was 1.2%, down from 2% in July—and the core rate, as defined by the Federal Reserve, has stubbornly stayed at 1.2%, close to its low point. There were inklings this week that some at the Fed want even looser monetary policy. True, things are improving in Japan, which seems finally to have escaped 15 years of falling prices, but even there underlying inflation is still only zero. The only big, rich economy where prices are rising at a clip is Britain, where overall inflation is 2.7%.

These are depressing numbers (see article). The most obvious danger of too-low inflation is the risk of slipping into outright deflation, when prices persistently fall. As Japan’s experience shows, deflation is both deeply damaging and hard to escape in weak economies with high debts. Since loans are fixed in nominal terms, falling wages and prices increase the burden of paying them. And once people expect prices to keep falling, they put off buying things, weakening the economy further. There is a real danger that this may happen in southern Europe. Greece’s consumer prices are now falling, as are Spain’s if you exclude the effect of one-off tax increases.

In America and northern Europe deflation is less of an immediate risk. Most economies are growing, albeit slowly. And surveys show consumers still expect medium-term inflation to be at or above the central banks’ target of 2%. But if an economy with high unemployment grows too slowly for too long, prices and wages are eventually likely to fall. In Japan deflation did not set in until seven years after the asset bubble burst.

Even without reaching that critical level, ultra-low inflation has costly side-effects. It tends to go with a weaker economy and higher-than-necessary joblessness: America’s unemployment rate is 7.2%, France’s 11.1% and Spain’s 26.6%. It also means that nominal incomes grow more slowly than they would if prices were rising faster. This makes both government and household debts harder to pay off. And low inflation makes it tougher for uncompetitive countries within a single currency to adjust their relative wages. With Germany’s inflation rate at 1.3%, Italian or Spanish firms need outright wage cuts to compete with German factories.

What’s more, too little inflation will undermine central bankers’ ability to combat another recession. Normally, during a period of growth bankers would raise rates. But policy rates are close to zero, and central bankers are reliant on “unconventional” measures to loosen monetary conditions, particularly “quantitative easing” (printing money to buy bonds) and “forward guidance” (promising to keep rates low for longer in a bid to prop up people’s expectations of future inflation). Should the economy slip back into recession, the central bankers will find themselves unusually impotent.

An attitude for altitude

Most rich countries, then, would be better off if consumer prices were rising a bit faster. But what is “a bit”, and how should central bankers go about nudging prices upwards without losing control of them? Too often in the past a bit of inflation has turned into a lot—with nasty consequences. And it is not as if central bankers have been doing nothing: from the Federal Reserve to the Bank of Japan, their balance-sheets have exploded. That has pumped up asset prices, and leads many to fret that dangerously higher consumer-price inflation will eventually appear too.

One response might be to raise official inflation targets, say from 2% to 4%. But changing what has been the cornerstone of central banking for decades could easily prove counter-productive, by unnerving financial markets. Nor is such radicalism yet necessary. Central bankers’ first step should be to work harder at reaching their existing inflation goals.

The European Central Bank, which cut its main policy rate from 0.5% to 0.25% on November 7th, still has the most work to do. Bolder moves to loosen financial conditions, including broad bond-buying and a new cheap financing facility for banks, are needed. The ECB must also stress that its target is an inflation rate close to 2% for the euro zone as a whole, even if that means higher inflation in Germany.

The Fed, which is still buying $85 billion-worth of bonds a month, does not need to expand quantitative easing. But it can change its forward guidance. This week’s kerfuffle was based on the idea that the Fed should reduce the “threshold” below which unemployment must fall before rates are raised, lowering it from 6.5% to 6% or below (see article). That looks a good idea. The Fed’s boss-in-waiting, Janet Yellen, could introduce an inflation threshold of, say, 1.75%: prices would have to rise faster than that for her to raise rates.

None of this means that inflation will not one day be a risk. But it is not today’s problem. All the “sound money” fanatics who issued dire warnings about rampant inflation when central bankers began their unconventional measures might usefully reconsider whether Western policymakers did too little, not too much. Be afraid of inflation, by all means; but life can be even scarier when it sinks.