Fear of deflation haunts investors and stalks the halls of the Federal Reserve in Washington.
But how bad are declining prices, and why have they become a problem? Should investors and the Fed stop worrying and learn to love deflation, at least at moderate levels?
For 70 years, deflation was a distant threat as policymakers and economists wrestled with the problem of taming high and persistent inflation rates instead. It started to become an issue in the 1990s when inflation dipped below 3 percent for the first time in three decades, sparking a debate about “optimal inflation rates” and how the Fed should define its price stability mandate.
Eventually a consensus emerged in favour of targeting a low but positive rate of inflation rather than either zero (absolute price stability) or declining prices (deflation). In the United States, the Fed has in practice defined price stability as an increase in non-food and energy prices somewhere between 1.5 and 2.25 percent per year.
Proponents cite “nominal rigidities” in wages and prices, interest rates and debt contracts as the reason to favour a non-zero rate of price rises. Inflation gives policymakers and businesses much needed flexibility to cut real wages, prices, interest rates and the debt burden when it is difficult to reduce them further in cash terms. Small amounts of inflation “oil the wheels” of the economy.