The world’s major central banks are currently obsessed with
the goal of raising their national inflation rates to their common target of
about 2% per year. This is true for the United States, where the annual
inflation rate was -0.1% over the past 12 months; for the United Kingdom, where
the most recent data show 0.3% price growth; and for the eurozone, where
consumer prices fell 0.6%. But is this a real problem?
The sharp decline in energy prices is the primary reason for
the recent drop in the inflation rate. In the U.S., the core inflation rate
(which strips out changes in volatile energy and food prices) was 1.6% over the
last 12 months. Moreover, the Federal Reserve, the Bank of England, and the
European Central Bank understand that even if energy prices do not rise in the
coming year, a stable price level for oil and other forms of energy will cause
the inflation rate to rise.
In the U.S., the inflation rate has also been depressed by
the rise in the value of the dollar relative to the euro and other currencies,
which has caused import prices to decline. This, too, is a “level effect,”
implying that the inflation rate will rise once the dollar’s exchange rate
stops appreciating.
But, despite this understanding, the major central banks
continue to maintain extremely low interest rates as a way to increase demand
and, with it, the rate of inflation. They are doing this by promising to keep
short-term rates low; maintaining large portfolios of private and government
bonds; and, in Europe and Japan, continuing to engage in large-scale asset
purchases.
The central bankers justify their concern about low
inflation by arguing that a negative demand shock could shift their economies
into a period of prolonged deflation, in which the overall price level declines
year after year. That would have two adverse effects on aggregate demand and
employment.
First, the falling price level would raise the real value of
the debts that households and firms owe, making them poorer and reducing their willingness
to spend. Second, negative inflation means that real interest rates rise,
because central banks cannot lower the nominal interest rate below zero. Higher
real interest rates, in turn, depress business investment and residential
construction.
In theory, by depressing aggregate demand, the combination
of increased real debt and higher real interest rates could lead to further
price declines, leading to even larger negative inflation rates. As a result,
the real interest rate would rise further, pushing the economy deeper into a
downward spiral of falling prices and declining demand.
Fortunately, we have relatively little experience with
deflation to test the downward-spiral theory. The most widely cited example of
a deflationary economy is Japan. But Japan has experienced a low rate of
inflation and some sustained short periods of deflation without ever producing
a downward price spiral. Japan’s inflation rate fell from nearly 8% in 1980 to
zero in 1987. It then stayed above zero until 1995, after which it remained low
but above zero until 1999, and then varied between zero and -1.7% until 2012.
Moreover, low inflation and periods of deflation did not
prevent real incomes from rising in Japan. From 1999 to 2013, real per capita
gross domestic product rose at an annual rate of about 1% (which reflected a
more modest rise of real GDP and an actual decline in population).
Why, then, are so many central bankers so worried about low
inflation rates?
One possible explanation is that they are concerned about
the loss of credibility implied by setting an inflation target of 2% and then
failing to come close to it year after year. Another possibility is that the
world’s major central banks are actually more concerned about real growth and
employment, and are using low inflation rates as an excuse to maintain
exceptionally generous monetary conditions. And yet a third explanation is that
central bankers want to keep interest rates low in order to reduce the budget
cost of large government debts.
None of this might matter were it not for the fact that
extremely low interest rates have fueled increased risk-taking by borrowers and
yield-hungry lenders. The result has been a massive mispricing of financial
assets. And that has created a growing risk of serious adverse effects on the
real economy when monetary policy normalizes and asset prices correct.
Martin Feldstein, professor of economics at Harvard
University and president emeritus of the National Bureau of Economic Research,
chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to
1984. Currently, he is on the board of directors of the Council on Foreign
Relations, the Trilateral Commission, and the Group of 30, a non-profit,
international body that seeks greater understanding of global economic issues –
MARTIN FELDSTEIN
(This article has been published with the permission of
Project Syndicate — The Deflation Bogeyman.
The writer is an emeritus professor of economist at Harvard.
Source: - Business Standard Date
03.03.2015)
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