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Who's Afraid of a Little Deflation?

November 17, 2014 in Economics

By John H. Cochrane

John H. Cochrane

With European inflation declining to 0.3%, and U.S. inflation slowing, a specter now haunts the Western world. Deflation, the Economist recently proclaimed, is a “pernicious threat” and “the world’s biggest economic problem.” Christine Lagarde , managing director of the International Monetary Fund, called deflation an “ogre” that could “prove disastrous for the recovery.”

True, a sudden, large and sharp collapse in prices, such as occurred in the early 1920s and 1930s, would be a problem: Debtors might fail, some prices and wages might not adjust quickly enough. But these deflations resulted directly from financial panics, when central banks couldn’t or didn’t accommodate a sudden demand for money.

The worry today is a slow slide toward falling prices, maybe 1% to 2% annually, with perpetually near-zero short-term interest rates. This scenario would unfold alongside positive, if sluggish, growth, ample money and low credit spreads, with financial panic long passed. And slight deflation has advantages. Milton Friedman long ago recognized slight deflation as the “optimal” monetary policy, since people and businesses can hold lots of cash without worrying about it losing value. So why do people think deflation, by itself, is a big problem?

1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.

Sticky wages would be a problem for a sharp 20% deflation. But not for steady 2% deflation. A typical worker’s earnings rise around 2% a year as he or she gains experience, and another 1% — hopefully more — from aggregate productivity growth. So there could be 3% deflation before a typical worker would have to take a wage cut. And the typical worker also changes jobs, and wages, every 4½ years. Moreover, “typical” is the middle of a highly volatile distribution of wage changes among a churning job market. Ultimately very few additional workers would have to take nominal wage cuts to accommodate 2% deflation.

Curiously, if sticky wages are the central problem, why do we not hear any loud cries to unstick wages: lower minimum wages, less unionization, less judicial meddling in wages such as comparable worth and disparate-impact discrimination suits, fewer occupational licenses and so forth?

: Bottom line? Relax.”

2) Monetary policy headroom. The Federal Reserve wants a 2% inflation rate. That’s because with “normal” 4% interest rates, …read more

Source: OP-EDS

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