Falling prices sound like something to cheer. In 1950 talk was not cheap. It cost $US3.70 to place a five-minute call between New York and San Francisco–or $US36.35 in today’s money.
Now that same call costs you nothing. The emergence of the sharing economy is driving down the price of a taxi ride and a bed for the night. More recently tumbling prices for natural resources, especially oil, have boosted the spending power of consumers from Detroit to Delhi. Mark Carney, the governor of the Bank of England, reckons that falling energy prices are “unambiguously good” for the British economy. Mr Carney is not wrong. Nonetheless, the world is grievously underestimating the danger of deflation.
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.
Deflation poses several risks, some well-understood, one not. One familiar danger is that consumers will put off spending in the expectation that things will get even cheaper, further muting demand. Likewise, if prices fall across an economy but wages do not, then firms’ margins will be squeezed and employment will stagnate or decline. (Neither of these dangers is yet visible; indeed, America and Britain are seeing strong employment growth.)
A third, well-known risk is debt deflation: debts become more onerous because the amount that is owed does not fall, even as earnings do. This is a big worry in the euro zone, where many banks are already stuffed with dud loans.
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.
All of which means that policymakers risk having precious little room for manoeuvre when the next recession hits. And sooner or later it will–because of a sharp slowdown in China, say, or the effect of a rising greenback on dollar-denominated corporate debt, or from some shock that comes out of the blue.
The Federal Reserve has cut its policy rate by an average of 3.9 percentage points in the six recessions since 1971. That would not be possible today. The break-glass-in-case-of-emergency option of depreciating the currency massively against a fast-growing trading partner is of limited use when so few big economies are growing rapidly and prices are falling, or close to it, in so many places.
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.
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