Since You Asked

Low inflation can be a disease not a cure

Deflation seems unlikely – but even a low risk is worth losing sleep over, writes Tim Harford

‘UK consumer inflation has fallen below the Bank of England’s 2 per cent target for the first time in four years.’ Financial Times, February 19

Hurrah!

Well, perhaps.

Why are you so grumpy again? What wrong with low inflation?

Nothing, so far – but you can have too much of a good thing. Inflation is also low and edging downwards in the US, Japan and the eurozone. Correction: Inflation is also low in Japan, and low and edging downwards in the US and the eurozone. Yet in all these places, interest rates are low and central bankers have printed enough money to get the tinfoil hat brigade screaming about hyperinflation. Such low inflation might be an indication of trouble ahead.

Are you saying that low inflation is a bad thing, or are you saying that low inflation is merely a harbinger of doom?

A bit of both – but mostly I am concerned that low inflation is a bad thing in itself. One issue is that unexpectedly low inflation redistributes from borrowers to creditors.

About time too, most savers will be thinking.

I hear you. Still, borrowers are more likely to be cash-constrained (that’s why they are borrowers) and are more at risk of bankruptcy. That means lower-than-expected inflation may damage the economy as a whole rather than just moving money from one person’s pocket to another’s. And there’s another problem with deflation: the “lower-bound” problem.

What’s that?

It’s a fancy way of saying that nominal interest rates can’t fall below zero. If inflation is, say, 4 per cent then a central bank can give an economy a shot of adrenalin by cutting interest rates after inflation to minus 3 or minus 4 per cent. If inflation is 0.7 per cent – as it’s currently estimated to be in the eurozone – then that’s impossible.

Why would anyone want real interest rates of minus 4 per cent?

Usually we wouldn’t. But, against the backdrop of a slack economy, such rates would be a strong incentive to spend. And if outright deflation took hold, effective interest rates would rise: people would earn money simply by sitting on their cash and waiting for prices to fall. Sounds great but for an economy it’s a disaster. If nobody buys anything there will be a recession and more deflation – a vicious spiral.

But that isn’t going to happen. Is it?

Don’t ask me, I’m an economist. We never know what’s going to happen to the economy. But it is a serious enough problem that even a low risk is worth losing sleep over.

Is there a constructive response?

In the case of the US and the UK, there’s always “hope for the best”. Both economies have been growing in a more-or-less encouraging fashion. One could try cutting taxes and raising government spending but it may be too late.

What about this forward guidance business?

Yes, an awkward affair. In principle forward guidance makes sense: the idea is to promise to keep interest rates very low until some condition is met, even if the economy might benefit from higher rates down the track.

Why make such a promise?

Because promising low rates for a long time is the next best thing to cutting rates below zero. Imagine buying a house: a mortgage rate of minus 3 per cent might be nice; but a promise that interest rates will be held artificially low for a while is almost as good, if you believe the promise.

That all makes sense.

Yes, but recent experiments with forward guidance haven’t been a huge success. Bank of England governor Mark Carney tied his forward guidance to unemployment rates, and unemployment rates promptly plummeted, so his attempt to commit to low interest rates ended up meaning very little. Still, it was worth a try.

This all seems flimsy. Are there any other approaches?

Most of these central banks are targeting inflation of 2 per cent, or something along those lines. But four years ago IMF chief economist Olivier Blanchard proposed a sharp break with that tradition. He floated the idea of a 4 per cent inflation target next time round. The thinking makes some sense: as long as interest rates and salaries tend to adjust, a higher target should cause little harm in good times and provide a great deal more room for manoeuvre in severe recessions.

That sounds radical.

Agreed. It’s never going to happen, which is a shame. But from the standpoint of today’s sluggish growth all Mr Blanchard’s advice would amount to is: “Next time let’s start from somewhere else.”

Also published at ft.com.