September 25, 2011
For far too long economists and economics reporters have fixated on the prospect of deflation, as though something really bad happens if the inflation rate falls below zero and becomes negative. This is another one of the ungodly silly things that otherwise intelligent people are inclined to believe.
Of course there is zero magic to zero. The problem is not a negative inflation rate per se, the problem is an inflation rate that is too low.
Given the weakness of the economy, we would like a large negative real interest rate. The federal funds rate is zero, which is as low as it could go, and even the long-term rate is approaching its lower limits. (People holding long-term bonds at very low interest rates risk large capital losses if interest rates rise at some future point.) This means that to get the real interest rate down, we need to get the inflation rate up.
One can dispute how large a negative real interest rate we would want (according to some measures of the Taylor Rule, it should be as high as – 6.0 percent), but the basic story is the higher the better. In this context a prolonged period of very low inflation is bad, even though a period of low deflation would be even worse. However, crossing zero is just a difference of quantity, not quality. There is no reason to be more upset about a drop in the inflation rate from 0.5 percent to -1.5 percent, than a drop from 1.5 percent to 0.5 percent.
Krugman essentially makes this point in his blogpost yesterday. Hopefully this will help to end the obsession with deflation. The point being that everything is not okay as long as the inflation rate just stays positive. Some of us have been saying this for a while (e.g. here, here and here), but it helps hugely to have Krugman making this point.
