The Deflation Sky May Not Be Falling

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Central banks may be exaggerating the deflation risk.


Deflation is portrayed as the great economic scourge.  It exacerbates debt-servicing costs and encourages consumers to defer purchases.  Central banks in Japan and Europe have responded with aggressive, unorthodox measures, often combining asset purchase programs with negative interest rates. 

However, deflation is not very deep, and the measurement is not very precise.  In recent years, it has become common for many central banks to define their mandate of price stability as being around 2% inflation.  This number is arbitrary, yet it has been turned into a fetish.   Is minus 0.2% CPI, which the Eurozone reported last week for the month of February, really that much different than +0.2% CPI? 

Nor does deflation necessarily mean economic weakness.   Sweden reported Q4 GDP of 1.3% quarter-over-quarter and a 4.5% year-over-year rate.  The central bank, however, is so concerned about deflation that it has negative interest rates and an ongoing bond-buying program.  Spain, also experiencing deflation, has among the fastest growing economies in the Eurozone.  The economy expanded by 0.8% in Q4 for a 3.5% year-over-year pace.  Earlier today, Switzerland reported Q4 GDP of 0.4%.  The market had expected 0.1% growth. 

Japan is the counter-example.  Deflationary pressures are becoming evident again, and the economy is struggling to find any traction.  Indeed, there is some risk that Q4 15 GDP is revised lower next week from the 1.4% contraction reported initially on an annualized basis.

The decline in inflation expectations in the US was cited by NY Fed President Dudley as an important factor that is likely change the Fed's growth and risk assessment.  That said, both core CPI and core PCE deflator have been slowly rising despite the firm dollar and low oil prices. 

Even unorthodox monetary policies seem unable to boost inflation (or inflation expectations). Plan B may be to focus on the consequences rather than the causes.  Draghi has argued that the central bank's credibility is on the line.  The ECB, he argues, is legally obligated to strive for the mandate.   In addition, to do so, means adopting policies whose implications (like negative interest rates) are not fully understood. 

The questions raised here is not an argument for the abdication of the central bank's responsibility.  Rather it is a note of caution that deflation has been demonized, while the economic consequences in Sweden and Spain, and secondarily in Switzerland, do not seem as severe as feared.  The economic consequences of a little deflation are not really much different from a little bit of inflation. The risks sacrificing time-tested economic principles at the altar of the 2% fetish may be greater than coping with real price stability.

Are Central Banks Exaggerating Deflation Risks? is republished with permission from Marc to Market

See also: Healing Wounds with a Recovery