Business faces problems in deflation – as the prices a company receives for its products or services decline, it will try to pay less for everything – materials, office space, capital and people. Renters will pressure landlords to lower rents, forcing down real estate values. If capital means bonds, business may face high real rates of interest if bonds were issued before prices began to fall. The it is equity capital, dividends are more expensive. Companies will cut wages and salaries; or, fearing that the best people may leave, will lay off workers. Were prices slowly rising rather than falling, companies would be able to raise wages and salaries by roughly the same proportion as the inflation rate without paying significantly more in inflation-adjusted wages.
These two factors – that interest rates cannot fall below zero and that people can accept a little bit of inflation with some money illusion – mean that moderate inflation is workable while moderate deflation is not. For either flation there is a large danger – as the rate expands, it becomes more volatile, less predictable and more damaging. That is why central banks were so proud of keeping inflation low in the 1980s and 1990s.
With prices rising less than 2% in the US, less than 1% in Europe and oil plunging by 20% since July, should we worry? The oil price plunge is a different story. While it does contribute to lower prices across the global economy, the drop in oil prices stems from new supply and the structure of the oil markets. The miniscule increases in prices, much below current policy targets, are a symptom of an economy where demand is growing more slowly than potential supply. In Europe, the US and Japan, there is sufficient underutilized labor and capital to support faster growth. Slowing or falling prices mean that people, business and government, out of either fear or risk aversion, prefers to hold on to its money rather than spending it. There is room to grow, we just need the right policy to get it started.
This article was written by David Blitzer, chairman of the index committee, S&P Dow Jones Indices.
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