Feldstein: Deflation Raises Questions about Global Recovery

Martin Feldstein has two worries. He's worried about deflation in the short-run, and about inflation in the longer run:

Deflation raises questions about global recovery, by Martin Feldstein, Project Syndicate: The rate of inflation is now close to zero in the US and several other major countries. The Economist recently reported that economists it had surveyed predict that consumer prices in the US and Japan will actually fall this year as a whole, while inflation in the euro zone will be only 0.6 percent. South Korea, Taiwan and Thailand will also see declines in consumer price levels. ...

Deflation is potentially a very serious problem, because falling prices — and the expectation that prices will continue to fall — would make the current economic downturn worse in three distinct ways.

The most direct adverse impact of deflation is to increase the real value of debt. ... [T]he price level could conceivably fall by a cumulative 10 percent over the next few years. If that happens, a homeowner with a mortgage would see the real value of his debt rise by 10 percent. Since price declines would bring with them wage declines, the ratio of monthly mortgage payments to wage income would rise.

In addition..., deflation would mean higher loan-to-value ratios for homeowners, leading to increased mortgage defaults... A lower price level would also increase the real value of business debt, weakening balance sheets and thus making it harder for companies to get additional credit.

The second adverse effect of deflation is to raise the real interest rate... Because ... central banks have driven their short-term interest rates close to zero, they cannot lower rates further in order to prevent deflation from raising the real rate of interest. Higher real interest rates discourage credit-financed purchases by households and businesses. This weakens overall demand, leading to steeper declines in prices.

The resulting unusual economic environment of falling prices and wages can also have a damaging psychological impact on households and businesses. ... If prices fall at a rate of 1 percent, could they fall at a rate of 10 percent? ... Such worries undermine confidence and make it harder to boost economic activity.

Some economists have said that the best way to deal with deflation is for the central bank to flood the economy with money in order to persuade the public that inflation will rise in the future... In fact, the Federal Reserve, the Bank of England, and the Bank of Japan are doing just that under the name of “quantitative easing.”

Not surprisingly, central bankers who are committed to a formal or informal inflation target of about 2 percent per year are unwilling to abandon their mandates openly and to assert that they are pursuing a high rate of inflation. Nevertheless, their expansionary actions have helped to raise long-term inflation expectations toward the target levels. ...

Ironically, although central banks are now focused on the problem of deflation, the more serious risk for the longer term is that inflation will rise rapidly as their economies recover and banks use the large volumes of recently accumulated reserves to create loans that expand spending and demand.