March 29, 2015
For some reason economics reporters and economists seem to have a really hard time understanding deflation. There are two lessons for today. First, we get the standard lesson: crossing zero means nothing, the problem is too low a rate of inflation.
As I’ve written a few thousand times, inflation is an aggregate measure that combines price changes of hundreds of thousands of goods and services. When the inflation rate gets near zero it means that than many of the price changes are already negative. Going from a near zero positive to a near zero negative just means a higher ratio of negative price changes to positive price changes (or the negative ones are larger). How can going from 45 percent negative price changes to 55 percent negative price changes be a disaster? That makes zero sense.
Furthermore, since these are all quality adjusted price changes it may not even be the case that prices are actually falling for the goods themselves. The price index for new cars in the United States is less than 3 percent above its 1998 level, yet the average new car costs considerably more in 2015 than it did in 1998. The difference is that the Bureau of Labor Statistics (BLS) attributes most of the price rise to quality improvements. The story would be even more dramatic with computers where BLS reports that prices have fallen by more than 95 percent since 1997. Does anyone believe that an economy faces disaster just because its cars and computers are getting better?
The problem of low inflation is that debt burdens become harder for people to deal with since wages tend to rise roughly in step with inflation. If a debt has fixed interest rate, like a standard mortgage, this is a greater burden when wages are rising 1.0 percent than when they are rising 3.0 percent. We also expect the value of homes to rise more or less in step with inflation. This means that in a low inflation environment, most homeowners will be accumulating equity less rapidly than if inflation were higher. And businesses making investment decisions will be more likely to invest if they think the goods they produce will be selling for 15 percent more in five years (@ 3.0 percent average inflation) as compared with 5 percent more (@1.0 percent average inflation).
In all three cases, crossing zero and having the inflation rate turn negative makes things worse, but only in the same way that going from 1.5 percent inflation to 0.5 percent inflation makes things worse. There is zero importance to crossing zero.
This logic should also help to explain why deflation due to a drop in the price of oil or other commodities is not a problem. Most immediately, lower oil and gas prices will mean more money in the pockets of consumers, which will allow them to buy more. At least initially it will not affect the rate of house price appreciation or the rate of increase in the price of other goods and services. Over time, a drop in commodity prices may end up slowing nominal wage growth and therefore the rate of increase in other prices, but the initial drop in inflation due to the fall in commodity prices is by itself a plus for the economy.
For these reasons, this Reuters article telling readers that China is concerned about deflation due to lower commodity prices was primarily trying to tell readers that its author/editor are confused about basic economics.
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