OK, boomers, remember when annual inflation approached or exceeded double digits? It was a mess, particularly for retirees. Nearly all pensions were fixed in dollar terms. This wasn’t a problem when inflation was low and life expectancy after retirement short.
But consider a pension worth $10,000 in 1972. In a decade’s time, that same payout was worth only $3,900.
We reacted by incorporating cost-of-living adjustments or COLAs into labor contracts, pension plans, Social Security, etc. That made inflation even more difficult to control, as the previous year’s price increase became the starting point for this one. It created many inequities, too—it was good for borrowers and bad for lenders, for example. It took the global economy and central banks a lot of effort to chain the inflation beast.
In my last post, I tackled the problem of measuring inflation and some of the causes of persistently low inflation. In this post, I’ll explore why low inflation causes angina among economists.
Consider the relationship between inflation and interest rates: The interest rate plays a dual function. First, it compensates a lender for giving up purchasing power during the period of the loan. Second, it compensates a lender for being paid back in currency with less purchasing power.
The power of a central bank—like the Federal Reserve or the European Central Bank—to influence the economy is largely derived from its ability to guide interest rates. If inflation is 6 percent and the “real” interest rate is 2 percent, then the “nominal” interest rate is 8 percent. A 2½ percent reduction in the federal funds rate effectively makes the real interest rate negative and strongly encourages businesses to borrow and invest. (See an explanation of the real interest rate here.)
By contrast, if the nominal interest rate is only 2 percent, then the power of the central bank to cut rates is much more limited. Central banks in Europe and Japan have actually driven their interest rates negative, but that’s hardly a strategy that can be adopted universally. And it says something about the economy: In these cases, confidence in the future had fallen so much that some investors preferred to pay to place their funds with the central bank (which is what a negative interest rate means) rather than put money into new or expanded business ventures. Interest rate reduction is the ammunition of monetary policy. Low inflation leaves central banks perilously short of bullets.
The vicious circle of deflation
Deflation—prices actually falling in nominal terms—is also problematic.
Rochester Gas and Electric has a rebate program for the installation of LED lights in commercial or industrial properties. Responsible for our church’s building, I’m considering it. Here’s my puzzle: The rebate cuts the price of replacing a 4-foot florescent tube to about $5. That’s cheap for a 4-foot LED today. But the prices have been falling so fast that I may just save the paperwork and wait for the unrebated price to hit $5.
If consumers expect prices to be lower tomorrow, they may choose to delay their purchases. When consumer spending slows, manufacturers lose business, lay off workers, who then spend less and so on. The economy can go into a tailspin.
These are issues that keep economists up at night. Low inflation is a problem as some stable level of inflation enables central banks to influence the economy. Low inflation can slip into deflation, which increases the risk of a downturn. So, here’s to inflation! May it live long and prosper. In my next post I’ll explore the associated problem of persistently low returns on long-term investment.
Kent Gardner is Rochester Beacon opinion editor.