In today’s story about the Fed raising interest rates another 0.25%, there was reference to the rate of inflation falling below the desired level (they didn’t say what the desired level of inflation is, at least not in the part of the story that I heard on NPR).
I sort of understand why deflation is not desirable, but I don’t understand why we need a minimum level of inflation to be economically healthy. Even relatively low inflation can cause problems for people on fixed incomes, or isn’t that of interest to economists any more?
I ask as a person who is on a pension which is fixed for the rest of my life (possibly 20 years or more); Social Security still has cost of living increases; and I am fortunate enough to be able to fill in the gaps from my IRA. Not everyone is so lucky. Why do we need a minimum level of inflation; and incidentally what is the minimum level desired by the Fed?
It is impossible to have the perfect long term price stability, so you have the choice between the inflation or the deflation.
The deflation is held to be by the economic evidence to substantially more problematic for the economy and harder to fight. The inflation is much easier to fight via the central bank interest rate policies and at a modest level is useful for the economic growth.
It is of course also the observation that the economic interests of the persons on the fixed incomes, a minority of the population do diverge from the interests of the economically productive portions of the economy, and the youth not yet economically productive but preparing for that. Their interest is for the inflation at a modest level generally, as the evidence in the economic history shows that moderate inflation has a lubrication effect on the economic growth excluding the technological change which can outweigh this. It is in the greater interest of the economy to priviledge the economic growth generating segments of the economy, as the policies that are ideal for the retiree are not good for economic growth. It is easier and cheaper to compensate the retired segment via the inflation indexing for the pensions and similar mechanisms.
The international standard among the central banks for a moderate level of the inflation is between the 2 and 3%. I believe the US target is 2%, which you are under.
There is discussion since the 2008 crisis that this target range is too low as it does not give a good enough cushion since now many developed world central banks are fighting against the Zero Lower Bound problem .
The goal is 2% annually and it’s set by the Federal Reserve, which explains itself here.
The other cite was good, but it did not really address that the reason for wanting businesses profitable is to ensure maximum employment. Employment is probably the biggest issue that concerns economists (IMO) and the best argument against pursing policies that allow people to spend less. Unfortunately.
Moderate inflation is bad for people on fixed incomes but deflation is devastating to an economy. Thus the Fed tries to keep inflation between 1% and 2%.
I don’t understand how deflation is “crippling”, though I can see why it is undesirable, especially to businesses.
But, for example, computers and electronics in general have been undergoing deflation for most of a century. My aunt bought a computer in 1989 that only ran DOS (and any actual software cost a significant amount extra, not to mention it had zero networking capabilities, let alone internet), and it was over $2000. A radio in the 1920s costs thousands of real dollars. Now you can get a far better computer for ~$100, and you can get a radio for a dollar or two. Yet, electronics and computers are still a huge and successful sector of the economy.
I can see why businesses don’t like it – why buy a smartphone today when you can wait a year and get one twice as good for half the price? – but it hasn’t seemed to “cripple” the economy, or even drive many consumer electronics businesses out of the market, though I admit it’s a cutthroat industry and margins are thin. But that’s true of other industries as well.
Imagine trying to get a picture of the Grand Canyon. The closer you get to the edge, the better your picture. So what’s the optimum distance from the edge? It’s not a millimeter, or even a foot, away, because even though that’ll get you a great picture, if you happen to lose your balance or misjudge a step, you’ve got a long way to fall.
Ideally, the economy might run best right on the edge, at 0%. But that carries the risk of slipping over the edge, so you want some safety margin between you and there. Economists have concluded that 2% is a good amount of safety margin, so that’s what they target.
In economic terms, the “Grand Canyon” is economic stagnation due to a feedback loop of inactivity and unemployment. Imagine everyone puts off as many purchases as possible because they know everything will be cheaper in the future. As demand drops along with prices, the inflation-adjusted cost of labor increases leading to layoffs. Leading to lower demand…and so on and so on. It also increases the real value of debt. With deflation, each mortgage payment represents MORE purchasing power put into your home, rather than less.
I’m not an economist but I don’t think this qualifies as deflation. The reason prices for PCs and smart phones go down and you get so much more for your money has to do with technological improvements in the products. Deflation would mean that prices for all products are going down, especially basics like food, housing and fuel. This puts a downward pressure on wages and on employment, as businesses have less money to spend on things like infrastructure maintenance and product improvements. These kinds of events seem to be associated with recessions and depressions.
eta: see the explanation of deflation immediately above this post, very clearly stated.
I guess I’m not clear why deflation is such a “cliff” that we have to be afraid of falling off.
it is very strange you separate out “businesses” as if negative impact on businesses is somehow seperate from the health of the economy.
The single sector decline in prices is not the same as the deflation of the economy, and when it is driven by the productivity and the technology gains like in that sector, is positive.
Again the very strange separation.
However the waiting habit cited is indeed one of the espects of the negatives of a full economy moving into deflation as the next two indicate.
This is correct, it may be added that when it is hitted sectors not experiencing the offsetting advances in the technological productivity the cycle becomes extemely negative. What Smith has highlighted is the destructive effects when there is the economy wide deflation. A single sector experiencing price decreases due to the productivity gains is not what is meant normally by deflation.
It is an observed fact from looking at the economic history that once an economy moves into general deflation, the reinforcing factors and the self-replicating pyschology is hard to reverse. The 1930s -globally not just USA - are taken as a key example although there are others.
The general conclusion of the economists and the policy makers in the monetary policy is that the challenges of the inflation side are ones that can be mastered. But moving into deflation runs high risks of being very hard to reverse and runs the high chance of self-reinforcing to Depressions.
Lower prices for certain goods because of technological innovation that makes producing those goods easier isn’t deflation. Prices falling because everything is cheaper to make and better isn’t deflation. So don’t think of inflation as prices rising and deflation as prices falling, think of inflation as a decrease in the value of money, and deflation as an increase in the value of money, all while the value of the underlying goods and services haven’t fundamentally changed.
People HATE to get pay cuts. That causes all sorts angst, crappy work, and political turmoil. In an inflationary environment everyone who doesn’t get a cost of living increase every year is taking a silent pay cut. One that usually goes unnoticed by most people.
In any economy there are always industries and companies that need to be raising their labor costs to attract more and/or better workers. And others that need to go the other way.
A little inflation is a lubricant that makes that second part of that equation go down a lot more easily. The “spoonful of, if not sugar at least olive oil, that helps the medicine go down.”
The horrific consequences of actual or near deflation is a much larger factor overall. But wage stickiness is in there as factor #2.
Others have given the reasons that the consensus of central bankers and economists is that low stable low inflation is better than zero or negative inflation, overall. Although the points made are not beyond debate. They reflect a consensus, not a unanimous opinion or plain fact.
But as to your concern about a fixed pension, you must consider that the pricing of this pension, in terms of how much labor you had to give to get it, reflected some expectation of inflation. If the providers had expected zero average inflation forever, they would presumably have required more labor from you to give a fixed pension of X than they actually did expecting say 2% inflation. This can be seen more directly in the prices of fixed annunities from insurance companies, which are basically the same thing as a fixed benefit pension except the annuitant hands over a lump sum of cash upfront, not some amount of labor. Back when inflation expectations in the US were higher and more uncertain, it required fewer 's upfront to get $X per year than it does now with low and stable inflation expectations. And these things really are the same. In fact I have a small fixed pension coming eventually from a former employee where the employer terminated the pension plan and simply bought us fixed annuities from a life insurance company. The price using the pension plan assets reflected expected inflation.
So you’d benefit, insofar as your interest as fixed pension holder, if inflation and inflation expectations dropped to zero. But it would be a windfall to you, rather than you having been screwed if inflation continues at the ~2% that was expected in the pricing of the pension benefit you received. People receiving fixed pensions accrued in the (lower inflation) 1940’s-60’s say but paid out in the (higher inflation) 70’s-80’s got screwed. I will only be screwed on that pension I mentioned if inflation plays out significantly higher than the ~2% expectation built into the pricing of it as of ca. 1990’s early 2000’s when I earned that benefit.
Corry El, that’s an interesting perspective that I hadn’t considered. Further on that thought, at the time when the pensions were negotiated (the union pensions pretty much set the standard for management pensions as well) inflation was higher than 2% and had been for a while, so the expectation might have been for a rate rather higher than 2%. So it’s quite possible that I am already getting a windfall.