Why Worry About Low Inflation?

On Friday, Federal Reserve Chairman Ben Bernanke all but promised that another round of monetary expansion is imminent. He emphasized that to take such a drastic measure, both aspects of the Fed's mandate would have to be invoked. Obviously unemployment is too high, and lately inflation has also been lower than U.S. central bankers would prefer. It's easy to understand why high unemployment is awful, but what's so bad about low inflation?

In fact, a 1% inflation rate isn't necessarily worse than a 2% inflation rate -- it's more about expectations. Since the market understands that the Fed targets an inflation rate of around 2%, when it sinks well below that, as it has recently, then the market may begin to change its expectation of the Fed's ability and desire to hit that target. This risk becomes even greater when interest rates are already near zero, as the Fed would have to rely on alternative means to raise prices. So the market's expectation could potentially lead to deflation -- particularly in a time when the economy is very slow and firms might already be cutting prices to conjure up more consumer demand.

So the problem is more one of instability. The fear is that deflation could eventually result if inflation is allowed to decline below its target. Deflation is a particularly dangerous problem, because central banks don't have strong tools to fight a deflationary spiral.

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But what's so bad about deflation? It can hurt an economy in several ways.

First, wages are sticky in general, but even stickier when needing to move downward. With inflation, it's pretty easy for employers to tell workers that their nominal wages are increasing. No arguments there. But it's much messier to force pay cuts. Employee morale suffers and unions often won't allow them. And Congress would probably never cut the minimum wage or Social Security benefits. So employers and lawmakers feel pressure to leave wages alone, as prices -- and consequently revenue -- decline. That leaves less money for expansion and additional hiring, which are both very desirable when unemployment is high and the economy is slow.

Next, deflation discourages spending. After all, if prices are declining, it's logical to wait a little while before making purchases you have planned. Until deflation ends, it's best to spend as little as possible, as the money you save will be worth more and more as deflation continues. Since spending is essential to economic recovery, this would also be a major problem right now.

Finally, this point extends to very large purchases like cars and homes that generally depend on loans. You don't want to be stuck with debt that will be harder to pay if your wages have to be cut due to deflation. Moreover, the value of those big purchases would decline with more deflation. The housing market is already miserable, and deflation would make it even worse.

If the Fed does fail to stabilize prices and prevent their further decline, then deflation could begin. That would make the recovery even slower, and possibly act as the catalyst to a double-dip. So even though it is not yet clear that the U.S. is on a path to deflation, you can begin to understand why the Fed might be concerned about even the vague possibility.