The dangers of deflation: The pendulum swings to the pit

Politicians and central bankers are not providing the world with the inflation it needs; some economies face damaging deflation instead

Oct 25th 2014 | WASHINGTON, DC | From the print edition: IT IS a pernicious threat, all the more so because, at its onset, it seems almost benign. After two generations of fighting against inflation, why be worried if the victory looks just a bit too complete, if the ancient enemy is so cowed as to no longer strain against the chains in which it is bound? But the stable low inflation fought for in the 1980s and 1990s and inflation hazardously close to zero are not so far apart. And as inflation drops, slipping into deflation becomes ever easier. It is in that dangerous position that the world now stands.

In America, Britain and the euro zone central banks have a 2% target for inflation. In all three, it is below that target. In Italy, Spain and Greece, which have experienced wrenching crises and recessions, it is below zero (as it also is in Sweden and Israel). Japan, which finally escaped from deflation in 2013 after more than a decade of struggle, is battling not to return. Leave out the effects of a consumption-tax increase and inflation there is barely half way to its 2% target. Even in China inflation is below 2%, compared with a 4% central government target (see chart 1).

The lowflation of being consistently below an already low target is bad in itself; the deflation it could easy lead to is even worse. There are several reasons. The belief that money made tomorrow will be worth less than money today stymies investment; the belief that goods bought tomorrow will be cheaper than goods bought today chokes consumption. Central bankers can no longer set real (that is, inflation-adjusted) interest rates low enough to restore demand.

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Measuring inflation: Counting the cost of living

The Fed and the White House wrestle with price indices

May 11th 2013 | WASHINGTON, DC |From the print edition
[Greg Ip] IN RECENT years inflation has been one of the few economic indices that has not caused much trouble to Americans. Contrary to repeated warnings, it has neither rocketed higher nor turned into deflation. But policymakers now face a different sort of inflation problem: determining which of many competing indices is giving the best picture of prices in America.

The most popular measure, the consumer price index (CPI), is a representative basket of goods and services drawn from a survey of the spending habits of 12,200 households. The index assumes that consumers buy the same quantity of each commodity from one period to the next until the basket is updated, every two years. The change in the cost of that basket is the inflation rate. But this almost certainly overstates the cost of living, because consumers continually adjust their spending patterns to buy more of what is cheap and less of what is dear.

America’s statisticians have known about this substitution bias since at least 1961, when a commission urged the development of a better index. In 1996 the Bureau of Economic Analysis (BEA) adopted “chain-weighted” indices—ones that are continuously updated to reflect changing spending patterns—to calculate real GDP. And in 2002 the Bureau of Labour Statistics (BLS) began calculating a chain-weighted version of the CPI.

The Federal Reserve’s inflation target: Shiny, new, unopened & unused

Jun 18th 2012, 16:35 by G.I. | WASHINGTON

When Federal Reserve officials meet this week, they will despondently confront an economy yet again falling short. Employment growth has flagged. GDP probably grew less than 2% (annualized) in the first half of this year; clouds from Europe, Asia and America’s own “fiscal cliff” darken the second half. The Federal Open Market Committee’s full year forecast of 2.4% to 2.9% looks out of reach.

So what will they do? Much of the street expects some kind of action, a view I share. It would probably come as an extension of “Operation Twist,” the purchase of longer-term bonds in exchange for short or medium bonds already in the Fed’s portfolio. It could stretch this out over a few months or a full year.

This, however, will be fiddling at the edges. What critics say the Fed needs is a wholesale makeover of its goals and methods. Some want the Fed to raise its inflation target. Others would have it adopt a nominal GDP target. Both approaches are intended to induce easier monetary policy that would foster faster growth in employment.  At the opposite end of the spectrum, more conservative economists and Republican legislators want to take away the Fed’s responsibility for full employment and have it focus solely on inflation.

Lost in this blizzard of outside advice is the fact that the Fed actually has a new framework of its own. In January it declared that henceforth its long-run target for inflation was 2%. Previously Fed members only stated their long-run preference, which ranged from 1.5% to 2%. It also said it considered its two statutory goals, low inflation and full employment, equally important. Previously, employment was, de facto, subordinate to inflation.

If you haven’t heard more about this, it’s because the Fed has treated the target like an unwanted Christmas gift, still unopened months after the tree has been taken down. The initial announcement was devoid of any hint of radicalism; it didn’t even use the word “target” or spell out the implications of its “balanced” approach to inflation and employment. It felt like the FOMC couldn’t agree on whether it was, or ought to be, a genuine departure. Indeed, the Fed acts as if nothing has changed. Its “appropriate” monetary policy in April yielded  forecast inflation of 2% or lower over the next few years. This vindicates critics who say the Fed acts as if 2% is a ceiling, not a target.

If the Fed were conducting policy based on this new framework, inflation would be centered around 2%. Indeed, if the Fed treated employment and inflation equally, it would likely tolerate inflation above 2% given that it is missing its full employment mandate more than its low inflation mandate. 

Explaining America’s macro puzzles: The worst of all worlds

Mar 15th 2012, 21:08 by G.I. | WASHINGTON

[Greg Ip] America’s economy is a mosaic of puzzles and contradictions that has economists and bloggers scrambling for explanations and scrutinizing the data for quirks and flaws. Lately, I’ve been thinking dark thoughts: what if all it takes is a single explanation that assumes all the data are correct?

Nominal GDP targeting will not provide a Volcker moment

Nov 1st 2011, 10:28 by G.I. | WASHINGTON

[Greg Ip] Early in his tenure as Fed chairman, Paul Volcker declared his intention to drive inflation lower. Soon after, he met with a group of businessmen. One told him, “’I listened carefully to you Mr Volcker, but I completed a wage agreement with my workers last week for 13% a year for each of the next 3 years. That’s what I think of prospects for inflation.’” Mr Volcker recalled the conversation last year, adding, “I always wondered what happened to that guy.”Mr Volcker’s anecdote exposes the flawed reasoning behind the newborn infatuation with nominal GDP targeting. Its advocates, which include my colleague, R.A. and Goldman Sachs, now include Christina Romer. In the New York Times she says just as Mr Volcker adopted money supply targeting to defeat inflation, Ben Bernanke should adopt NGDP targeting to restore full employment. She writes:

[Volcker] believed that by backing up his commitment to lower inflation with a new policy framework, he would break people’s inflationary expectations. So the Fed began to explicitly target the rate of money growth. Like the Volcker money target, [an NGDP target] would be a powerful communication tool. By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth. Such expectations could increase spending and growth today

The problem with her argument is that as the story of the hapless businessman, and studies such as this one, illustrate, Mr Volcker’s policy did not succeed by changing people’s expectations of inflation. It succeeded by crushing demand.

Oil markets and Arab unrest: The price of fear

A complex chain of cause and effect links the Arab world’s turmoil to the health of the world economy

Mar 3rd 2011 | BREGA, LONDON AND WASHINGTON, DC | from the print edition

[Greg Ip and colleagues] TWO factors determine the price of a barrel of oil: the fundamental laws of supply and demand, and naked fear. Both are being tested by the violence that is tearing through Libya, the world’s 13th-largest oil exporter. The price of a barrel of Brent crude now hovers around $115. On February 24th, however, it rose to almost $120, as traders realised that they might have to do for a while without some or all of Libya’s exports: some 1.4m barrels a day (b/d), or about 2% of the world’s needs.

The entire article is linked here.

Inflation lessons from the Asian crisis

Feb 9th 2011, 23:01 by G.I. | WASHINGTON

FOR those convinced that America is on the verge of becoming Weimar Germany, the high price of oil and gold are exhibits one and two. Often forgotten is the fact that both are traded in global markets and reflect global, not American, demand. Failing to appreciate the distinction can lead to policy mistakes. Just look at 1998.

A financial crisis tipped east Asia into a deep recession in 1997-98, which spread to Russia and then the United States via Long Term Capital Management. To cushion the spillover to America, the Fed first aborted a nascent monetary tightening cycle, then actually cut interest rates. It could do so in part because collapsing Asian demand crushed the price of oil, sending headline inflation below 2%.

Economics focus: Level Worship

Price-level targeting could make monetary policy more potent—or just more confusing

Oct 28th 2010

[Greg Ip] EVER since Ben Bernanke, the chairman of the Federal Reserve, signalled in the summer that he stood ready to keep using unconventional monetary policy to shore up America’s fragile economic recovery, expectations have been building that the Fed will launch a second programme of quantitative easing (QE)—the purchase of bonds with newly printed money. That moment is likely to come at the Fed’s meeting on November 2nd-3rd. Whether QE2 can live up to the hype is another matter. QE aims to stimulate demand by lowering nominal long-term interest rates, much as conventional monetary easing works by lowering short-term nominal rates. But with short-term rates already close to zero and long-term rates also very low, the room for further reductions in nominal rates is tight.

There may in any case be another way to achieve the same stimulus. What matters for boosting demand is the real interest rate—the nominal rate minus expected inflation—since inflation reduces the burden of repaying debt. If nominal rates cannot fall any further, why not raise expected inflation? Central bankers have roundly rejected the most obvious way to do that. Raising official inflation-rate targets, they say, would destroy years of hard-won credibility. But they are more receptive to another idea: targeting the level of prices rather than the inflation rate.

The entire article is linked here.

Economics focus: A winding path to inflation

Even if governments could create inflation, they may not want to

Jun 3rd 2010

 [Greg Ip] IN THE short run inflation is an economic phenomenon. In the long run it is a political one. This week The Economist asked a group of leading economists whether they reckoned inflation or deflation was the greater threat; this was our inaugural question in “Economics by invitation”, an online forum of more than 50 eminent economists. The rough consensus was that in the near term, as Western economies struggle to recover, the bigger worry there is deflation. But as the time horizon lengthened, more experts cited inflation, because it seems the most plausible exit strategy for governments trying to deal with crushing debts. “Deflation is not a lasting threat,” wrote Arminio Fraga, a former president of Brazil’s central bank. “The more interesting question is whether they can manage to keep inflation down over time under the regime of fiscal irresponsibility now prevailing almost everywhere.”

 

The inflation rate: Price puzzle

 

Inflation figures fuel a debate over when the Fed should tighten

Mar 18th 2010 | WASHINGTON, DC | From The Economist print edition

[Greg Ip] TRACKING American interest rates is like watching paint dry. At its meeting on March 16th the Federal Reserve left its short-term rate target between zero and 0.25% for the tenth consecutive time, and, given “subdued inflation trends”, said it would probably leave it there for an “extended period”.

But just how subdued is inflation really? Frustratingly, the latest data provide ammunition for both the hawks, who question the need for extended low rates, and the doves, who don’t.