FALLING prices sound like something to cheer…
The problem is that aggregate prices are dipping in so many places at once. Deflationary pressures are visible far beyond food and energy, and in countries that cannot claim to be leading the charge towards the new economy. In the euro zone, where deflation grips tightest, consumer prices fell by 0.6% in the year to January; Germany, Italy and Spain all saw falls. Prices in Greece have been declining for 23 months. Ultra-low inflation is also widespread. America, Britain and China each have inflation rates of less than 1%. This looks less like a welcome jolt to prices than a sign of entrenched weak demand.
The least-understood danger is also the most serious, because it is already here. Deflation makes it harder to loosen monetary policy. When inflation is at 4%, the central bank can take real (ie, inflation-adjusted) rates well below zero, to -4%, by keeping headline rates at zero. But as inflation falls and turns negative, low real rates get harder and harder to achieve—just when you need them most. Most rich-world central banks have already cut their main policy rates near to zero in order to pep up demand. A growing number of European economies are using negative interest rates to encourage spending, although charging people to put money in the bank will eventually prompt them to use the mattress instead (see article).
All of which means that policymakers risk having precious little room for manoeuvre when the next recession hits…
Change the target
Policymakers should be more worried than they appear to be, and their actions to avert deflation should be bolder. Governments need to boost demand by spending more on infrastructure; central banks should err on the side of looseness. (Next month the ECB will start quantitative easing—and about time too.) Now is also the moment to consider revising the monetary rule book—in particular, to switch the central bankers’ target from the inflation rate that most now favour to a goal for the level of nominal GDP, the total value of spending in an economy before adjusting for inflation. With such a target there is no need to distinguish between good and bad price shocks. And the change in rules would itself send a signal that policymakers are serious about banishing the threat of deflation.
Central bankers change course slowly, and their allegiance to inflation targets runs deep. Conservatism often serves them well. But in this case it could cost the world economy dearly.
Meanwhile, the Fed is discussing changing the “price object”. A fudge!
Some Federal Reserve officials discussing low inflation at their January policy meeting noted that some measures suggest less weakness than others.
“It was pointed out that the recent intensification of downward pressure on inflation reflected price movements that were concentrated in a narrow range of items in households’