April 08, 2016
The problem of deflation just refuses to go away. I don’t mean the problem of weak economies with very low inflation rates, I mean the media’s obsession with the idea that something really bad happens if the rate of price change crosses zero and turns negative.
We got another example of this strange concern in the NYT this morning. The piece noted the European Central Bank’s (ECB) concern:
“Still, the central bank acknowledged its deep concern about the risk that the eurozone’s economic doldrums, characterized by a worrisomely low rate of inflation, could devolve into outright deflation, a vicious circle of falling prices and demand that can undercut corporate profits and cause unemployment to soar. …
“Deflation sets in when falling prices prompt people to delay purchases because they expect prices to fall even further. Consumer spending and investment collapse, companies dismiss workers, and spending falls even further as people lose their jobs and incomes. Central bankers fear deflation because once it sets in, it is notoriously difficult to reverse.”
To see the silliness of this line of argument, consider first what falling prices literally mean. Suppose that the price of shoes is declining at a 0.5 percent annual rate. How long will you put off a purchase of a $100 pair, knowing that it you wait a year it will save you 50 cents?
My guess is that a moderate rate of deflation will have no measurable effect on consumers willingness to buy most items but, while you’re waiting for prices to fall more, consider what the inflation rate is. It is basket of goods and services that combines together literally millions of different price changes.
The overall inflation rate is an aggregate. When it nears zero, we should expect that the price of close to half of the items in the index are already falling. Crossing zero just means a rise in the percentage of price changes that are negative. That’s bad news in the context of wanting to see more rapid inflation in order to reduce real interest rates, but the crossing of zero means nothing. The bad news is that a below zero inflation rate is lower than an above zero inflation rate.
To make the fixation on zero even more absurd, these measures are quality adjusted prices. The price index may show that the price of a new Ford has fallen by 2.0 percent even though the sticker price has risen by 3.0 percent. The reason is that the Bureau of Labor Statistics (BLS) (or a statistical agency near you) has determined that various quality improvements to the Ford are worth 5.0 percent of lat year’s sticker price. BLS could be correct in this assessment, but that doesn’t mean everyone will see it that way. A vastly improved air conditioning system may not matter much to the folks in Alaska.
In short, crossing zero means nothing in the effort to boost inflation rates in the hope of spurring the economy. The problem is simply that inflation is lower than desired, not that it is negative.
This does matter, because often it is seen as somewhat of a victory that the ECB has been able to keep the inflation rate in positive territory. It isn’t. The inflation rate is too low, which makes it impossible to lower real interest rates enough to give a substantial boost to the economy. A negative inflation rate would make things worse, but no more so than any decline in the inflation rate makes things worse when the inflation rate is already too low.
Addendum
Since some comments asked about which prices are falling, I thought I’d give you a partial list from the Bureau of Labor Statistics’ (BLS) consumer price index. From the March release, here are the changes in prices over the last twelve months for the following items:
cereal and bakery products -0.3%
meat, poultry, and fish -4.3%
dairy products -2.6%
coffee -2.7%
gas -20.7%
electricity -3.0%
household furnishings and supplies -1.0%
men’s apparel -0.4%
non-prescription drugs -1.8%
sporting goods -1.8%
personal computers -7.9%
airline fares -1.8%
This is not an exhaustive list of all the categories of items with falling prices, but it should give folks a reasonable idea. I know that differences within these categories and some stores may raise their prices even if the nationwide average is falling. But clearly the prices of many items are dropping in large parts of the country. If you want to say you don’t believe the BLS numbers, then be careful you don’t fall off the edge of the earth.
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