Belgium (Brussels Morning Newspaper) Headline inflation fell from 7% in April to an annually adjusted 6.1% in May, announced Eurostat. Retail prices will follow suit in a few months. Core inflation – a more relevant indicator – is down to 5.3%.
But is it necessarily a good thing? I argue that it is time to consider the twin risks of recession and deflation. The recent bout of inflation was not structural but conjectural: the outcome of a set of unprecedented circumstances (the pandemic followed by the war in Ukraine). As the former recedes and the latter stagnates, inflation will abate, willy-nilly.
The role of the ECB is confined to taming prices and ensuring monetary stability, without second guessing the markets, even when these are evidently in the throes of asset bubbles.
In the past few decades, this obsession with price stability led to policy excesses as disinflation gave way to deflation – arguably an economic ill far more pernicious than inflation.
Deflation coupled with negative savings and monstrous debt burdens can lead to prolonged periods of zero or negative growth.
Moreover, in the zealous crusade waged globally against fiscal and monetary expansion – the merits and benefits of inflation have often been overlooked.
As economists are wont to point out time and again, inflation is not the inevitable outcome of growth. It merely reflects the output gap between actual and potential GDP.
As long as the gap is negative – i.e., whilst the economy is drowning in spare capacity – inflation lies dormant. The gap widens if growth is anemic and below the economy’s potential. Thus, growth can actually be accompanied by deflation.
Indeed, it is arguable whether inflation had been ever subdued by the farsighted policies of central bankers. A better explanation might be overcapacity – both domestic and global – wrought by decades of inflation which distorted investment decisions. Excess capacity coupled with increasing competition, globalization, privatization, and deregulation led to ferocious price wars and to consistently declining prices.
Taming inflation can easily get out of hand.
A truer gauge of forward-looking price pressures is the implicit price deflator of the non-financial business sector. Using this indicator, inflationary shocks often give way to deflationary and recessionary aftershocks.
Depending on one’s point of view, this is a self-reinforcing virtuous – or vicious – cycle. Consumers learn to expect lower prices – i.e., inflationary expectations fall and, with them, inflation itself. The intervention of central banks only hastens the process. But benign structural disinflation can transmogrify into malignant deflation.
It is universally accepted that inflation leads to the misallocation of economic resources by distorting the price signal. Confronted with a general rise in prices, people get confused. They are not sure whether to attribute the surging prices to a real spurt in demand, to speculation, inflation, or what. They often make the wrong decisions.
They postpone investments, or over-invest, or embark on preemptive buying sprees. As Erica Groshen and Mark Schweitzer have demonstrated in an NBER working paper titled “Identifying inflation’s grease and sand effects in the labour market”, employers – unable to predict tomorrow’s wages – hire less.
Still, the late preeminent economist James Tobin went as far as calling inflation “the grease on the wheels of the economy”.
What rate of inflation is desirable? The answer is: it depends on whom you ask. The European Central Bank maintains an annual target of 2 percent. Other central banks – the Bank of England, for instance – proffer an “inflation band” of between 1.5 and 2.5 percent. The Fed has been known to tolerate inflation rates of 3-4 percent.
These disparities among essentially similar economies reflect pervasive disagreements over what is being quantified by the rate of inflation and when and how it should be managed.
The sin committed by most central banks is their lack of symmetry. They signal a visceral aversion to inflation – but ignore the risk of deflation altogether. As inflation subsides, disinflation seamlessly fades into deflation. People – accustomed to the deflationary bias of central banks – expect prices to continue to fall. They defer consumption. This leads to inextricable and all-pervasive recessions.
The Mismeasurement of Inflation
Inflation rates – as measured by price indices – fail to capture important economic realities.
As the Boskin Commission revealed in 1996, some products are transformed by innovative technology even as their prices decline or remain stable. Such upheavals are not captured by the rigid categories of the questionnaires used by bureaus of statistics the world over to compile price data.
Cellular phones, for instance, were not part of the consumption basket underlying the CPI in America as late as 1998. The consumer price index in the USA may be overstated by one percentage point year in and year out, was the startling conclusion in the commission’s report.
Current inflation measures neglect to take into account whole classes of prices – for instance, tradable securities. Wages – the price of labor – are left out. The price of money – interest rates – is excluded. Even if these were to be included, the way inflation is defined and measured today, they would have been grossly misrepresented.
Consider a deflationary environment in which stagnant wages and zero interest rates can still have a – negative or positive – inflationary effect. In real terms, in deflation, both wages and interest rates increase relentlessly even when they stay put. Yet it is hard to incorporate this “downward stickiness” into present-day inflation measures.
The methodology of computing inflation obscures many of the “quantum effects” in the borderline between inflation and deflation. Thus, as pointed out by George Akerloff, William Dickens, and George Perry in “The Macroeconomics of Low Inflation” (Brookings Papers on Economic Activity, 1996), inflation allows employers to cut real wages.
Workers may agree to a 2 percent pay rise in an economy with 3 percent inflation. They are unlikely to accept a pay cut even when inflation is zero or less. This is called the “money illusion”. Admittedly, it is less pronounced when compensation is linked to performance.
(To be continued)
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