By: Megan Shuker
American, Britain and Euro Zone central banks have a 2% target for inflation. Eurozone inflation is 0.4%. The rate of UK inflation fell to 1.2% in September; its lowest rate for five years and the US is coming in at 1.7%. In the EU, the inflation rate has now been below 1.0% for 12 straight months. Ireland, France, Denmark, Netherlands, Belgium, Sweden, Portugal, Italy, Poland, Spain, and Greece all fell below 0%, with Greece at a full point below zero at -1.1%
By coming in below target, central banks and politicians are walking a risky line between lowflation and deflation. The following areas are directly affected by the threat: Investment, Consumer Purchasing, Central Bank Interest Rates, Wages, Tax Revenue, and Debt Repayment. Just the idea that tomorrow’s money won’t be worth as much as today’s limits each area separately. Investments stall, consumers hold out for lower prices, tax revenue plunges as wages decrease causing governments and individuals to default on debt.
The risk is especially poignant because Central Banks across the world already have artificially low rates to encourage spending but are failing to spur demand. Alternative policies to achieve faster growth say we must increase the growth rate of physical capital, the pace of technological advance, or the growth rate of human capital and openness to international trade. This can be done by: Savings Stimulus, Investment in Research & Development, Education Quality Improvement, Providing aide to developing nations, or encouraging international trade. These policies have been continuously blocked by politicians, and based on the recent election in the United States, the blockage is set to continue for at least the next two years.
Oil prices falling have contributed to the lower inflation rates. This price drop has been partially fuelled by a sharp increase in supply, but also as a result of the slowing economic growth around the world. Even China’s inflation is underwhelming at 2% compared to its 4% target.
A short period of deflation caused by the lower oil prices could be acceptable, and the world economy has even tolerated this situation in the past. Most notably, in America’s 1880’s output rose by 2-3% per year signaling growth, but since growth in the monetary supply was constrained, wages stagnated or fell, and ultimately hurt workers in the end. In contrast to this “good deflation”, “bad deflation” occurs when demand consistently falls short of aggregate supply, leaving inventories high and causing firms to decrease prices, consequently affecting profits and incomes. As incomes fall, debts rise and consumer spending slides even further as borrowers attempt to repay debts creating a vicious downward spiral: spending drops, wages drop, debts become more burdensome.
Governments can attempt to stop the spiral using debt, but with conditions. Since the economic downturn of 2008 public and private debts have reached 272% of developed-world GDP. So while household debts may be coming down, governments are picking up the slack. Investors are buying US five-year federal debt at such low rates that the nominal interest rate (rate minus Inflation rate) is trending towards -1%. As long as governments are able to continue borrowing at these low rates, the debts are bearable. If deflation, however, sets in and investors require a higher rate, the debt spiral will continue and thoughts of default will arise, and lending will cease.
Central Banks try to combat this lowflation by keeping rates low. However, when demand is weak the real rate (nominal rate minus rate of inflation ) may well be below zero. In these conditions it is nearly impossible for these central banks to combat deflation alone, politicians must take a stand as well.