December 26, 2014
Confused thinking on inflation continues to abound, and not just from the folks convinced that hyper-inflation is just around the corner or already here. Recall that until recently we were supposed to be terrified that those low inflation rates in the euro zone might shift from being small positives to small negatives, and then the world would end.
Fortunately the I.M.F., among others, is now pointing out that the problem is simply an inflation rate that is too low. An inflation rate of -0.5 is more too low low than inflation of 0.5 percent, but this is just in the same way that an inflation rate of 0.5 percent is more too low than an inflation rate of 1.5 percent. The problem is that we would like the inflation rate to be higher to both facilitate declines in real wages in sectors seeing less demand (commentators please note, the issue of real wages being too high is in certain sectors, not a general problem) and to reduce the real value of outstanding debt. A higher rate of inflation will also reduce the real interest rate, which will encourage firms to invest more.
This brings us to a Reuters story that ran in the NYT telling readers that falling oil prices will make it harder for Japan to hit its 2.0 percent inflation target, therefore implying that low oil prices are bad for Japan’s economy. Let’s think this one through for a moment.
First, if we check the base paths, we see that Japan is almost 100 percent dependent on imported oil. This is different from the U.S. which has a substantial oil producing sector. That should make the story pretty unambiguous. In the U.S. we can say that areas like North Dakota and Texas might take a hit, even if other parts of the country will benefit from lower oil prices. Japan doesn’t have a North Dakota or Texas, which means that they are only looking at paying less for their energy.
So how is this bad? Well, the Reuters piece says it means lower inflation. This is true, but we have to think of why lower inflation could be a problem. Let’s imagine that if the price of oil were unchanged, then Japan’s central bank would be hitting its 2.0 percent inflation target. Now because of lower oil prices, the overall rate of inflation will come in substantially under 2.0 percent.
From the standpoint of firms that are looking to lower real wages due to a fall in demand, how does the drop in oil prices make the situation worse. If the price of their output is falling relative to other, non-oil prices, and wages are falling as well in relative terms, these firms will be just as able to bring about the necessary price and wage adjustments as if the price of oil had not changed.
In terms of eroding the real value of debt, the drop in oil prices actually helps. Homeowners and others who have fixed nominal debts, will now see their income go further, if they can pay less for their gas, heating, and electricity. In other words, the debt is less of a burden to them.
Similarly, the real interest rate story is not affected by the drop in oil prices. If firms expect the price of software, cars, and other items to rise 2.0 percent a year, they have every bit as much incentive to invest after the drop in oil prices as before. (Actually, they would probably have more incentive, since the increased consumer demand for non-oil products will make investments look more attractive.)
In short, there is no plausible story in which the economy of a country like Japan, with little domestic oil production, is not benefited by lower oil prices. (Now, the story with global warming is very different.)
So let’s get this deflation bogeyman straightened up. If inflation is below target solely because of the dropping oil prices, this is what is technically defined as “not a problem.”
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