Is it possible for inflation to be too low?
I was listening to Fed chairman Ben Bernanke the other night speak at a press conference (I know, I need to get a life). Anyway, he said something that struck me as very contrary to the way most people think. He said -- and I am paraphrasing -- that while inflation can certainly be too high, it can also be too low.
Actually, I agree with him. So it’s Ben and me against perhaps the majority of people, who think inflation can never be too low. Let me see if I can explain my (and Ben’s) thinking, and then let you decide if we’re way off course.
First, here’s the easy part. Most agree inflation can be too high for both the good of the economy as well as the good of most people. Of course, by inflation I mean the rise in an average of prices, which some translate to mean a rise in the cost of living. While there’s a technical difference between the two, I won’t quibble.
Higher inflation hurts households in several ways. It means we have to pay more for the things we buy. It means, therefore, we have to get bigger pay raises to keep up with the higher cost of living, which, to say the least, is very difficult in today’s challenging economy. It also means we have to earn more on our investments to keep ahead of the erosive power inflation has on the value of our invested dollars. Sometimes that means taking more risk in our investments.
High inflation also drives up interest rates, making it harder to borrow money to purchase a home, vehicle and furniture, and for younger people, it’s more expensive to borrow money for college.
Last, inflation makes it difficult for the “signaling power” of price changes to work their magic. Changes in the price of a product (or service) give us important information about its relative scarcity. When the price rises, that tells us the product is scarcer, and more people are trying to buy a limited supply. The higher price motivates many of us to look for alternatives.
Conversely, when the price of a product drops, it says supplies are abundant and the product is a relative bargain. This motivates many people to stock up while the bargain lasts.
High inflation makes it tougher for these price signals to come through. If most of a price change is simply due to inflation, then inflation can overwhelm -- or mask -- any price fluctuations due to fundamental changes in supply or demand.
The last time we had very high inflation was in the late 1970s and early 1980s, when the rate hit double-digits and mortgage rates for home loans were near 20 percent. Fortunately, we’re nowhere near those levels today. Most measures of retail inflation – again, averaged over all products and services consumers typically buy -- are hovering between 1 percent and 2 percent annually.
Now let’s go to the hard part of my task today. Can inflation ever be too low? Chairman Bernanke thinks so. I also think so. But are we thinking clearly?
Actually, when Chairman Bernanke worries about low inflation, his concern is really about negative inflation, meaning a sustained drop in average prices. Yet, what would be so bad about seeing lower prices in stores, shopping centers and malls?
There can be several problems. Wages and salaries would also drop along with prices. If business revenues are lower due to lower prices, then firms have fewer funds to pay workers.
Debts would also become more difficult to pay. Debt payments – say, on a home mortgage or car loan -- are usually specified in a set dollar amount, like $250 or $500 a month. But negative inflation increases the purchasing power of the dollar, making the dollars repaid worth more. This adverse impact is made even worse if the household’s salary has also dropped.
Falling prices can motivate households to postpone buying, obviously thinking products and services will cost less in the future. But since 70 percent of our economy is driven by consumer spending, any significant slowdown in household buying can send the economy into a tailspin.
It is for these reasons that negative inflation (technically called deflation) can be scary for the economy. Economists think the negative inflation that occurred in the 1930s in our country and in 1990s Japan contributed to the lousy economy in both of those periods. The last time we had negative inflation was 2009, and that wasn’t a very good year for households or businesses.
So like with many things in life, too much of a good thing can actually be bad. In this case, the “good thing” is low inflation, and the “too much” is inflation that is so low it is negative. This is what Ben Bernanke means when he says he will defend against inflation being both too high and too low. You decide if he’s right!
Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy.