Deflation – Not Inflation – Is The Real Threat (Central Bank Week In Review For 8/31-9/4)

On Aug. 27, the Fed announced a new inflation targeting regime:

On price stability, the FOMC adjusted its strategy for achieving its longer-run inflation goal of 2 percent by noting that it “seeks to achieve inflation that averages 2 percent over time.” To this end, the revised statement states that “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

There are several reasons for the change. The first is that the market interpreted the previous “symmetrical” program as imposing an inflation ceiling. Vice President Clarida explains (emphasis added):

For example, under our previous flexible inflation-targeting framework, the Federal Reserve declared that the 2 percent inflation objective is “symmetric.” This term has been interpreted by many observers to mean that the Committee’s reaction function aimed to be symmetric on either side of the 2 percent inflation goal, and that the FOMC set policy with the (ex ante) aim that the 2 percent goal should represent an inflation ceiling in economic expansions following economic downturns in which inflation falls below target.

A second reason for this change of course is that low inflation — which increases the possibility of deflation — is now the global norm.

Above is a chart for the EU’s core inflation rate since 2002. It last hit 2% in 2007-2009. Even then it barely moved above that level and then only for a little more than a year. Since then prices have trended lower.The situation in Japan is more pronounced. The blue line shows the absolute value of the CPI using the left scale. Prices have been near stagnant for over 20 years. The red line shows the Y/Y percentage change in CPI, which has only moved above 3% once in the last 25 years.

Above is a chart for the Y/Y percentage change in core CPI (in blue) and the core PCE price index (in red). Both have been very tame for about 20 years.

Low inflation is reflected in r* – the hypothetical interest rate that’s neither stimulative nor restrictive. The Richmond Fed calculates this amount as:

The data leads to this conclusion: In the developed world, deflation is far more a threat than inflation.

There are four reasons for weak pricing pressures. First, the EU, US, and Japan’s populations are trending older. As this occurs, people save more and consume less. The former increases the amount of available funds while the latter eases demand-pull pressures. Both lead to lower inflation. This was first explained by Ben Bernanke in his Global Savings Glut paper. Second, increased global competition has helped to contain costs. Third, increased price transparency – especially as a result of the web – has given purchasers more negotiating power. Fourth, the de-unionization of the US labor force has lowered wage pressures.

Now, let’s return to the Fed’s statement about inflation. They said they would tolerate a 2% average rate of inflation. Using simple numbers, let’s say the PCE price index is 1% for 10 months. It would have to run at 3% for the next 10 months before the Fed would raise rates. At this point, some people will argue that inflation could run out of control. But that ignores a basic fact: Deflation is now the primary threat to the US economy. Put another way, inflation just isn’t a problem right now.

For those of us who came of age during the 1970s and 1980s, the idea of tolerating higher inflation seems anathema. But Paul Volcker successfully broke inflation in the early 1980s, bring in the “great moderation.” Now the possibility of an extended period of deflation is far greater. The Fed is now doing everything it can to encourage and cultivate pricing pressure.

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