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The ECB’s Deflation Obsession

It is hard to understand why the European Central Bank is currently so anxious to find new ways to make its policy stance even more expansionary. Its hyper-vigilance about falling prices is misplaced, and its ability to increase the rate of inflation is dubious.

BRUSSELS – Central banks aim for price stability, and today, prices are largely stable across much of the developed world. Yet central bankers declare themselves unsatisfied. Some policymakers, most notably at the European Central Bank, are even preparing further stimulus measures aimed at convincing financial markets of their resolve to fight deflation. But such policies overestimate the risk of falling prices.

For starters, prices are not falling now; they are just increasing more slowly than central bankers would like. In the eurozone, for example, core inflation (which excludes volatile energy and food prices) is running at about 1% per year, and markets expect it to remain at this level, on average, for the next decade.

The ECB regards such low inflation as totally unacceptable. It defines “price stability” not as stable – that is, unchanging – prices, but as year-on-year eurozone inflation of “below, but close to, 2% over the medium term.” Similarly, the United States Federal Reserve and the Bank of Japan have inflation targets of 2%.

Central banks are afraid of stable prices for two reasons. The first is that the real value of debt automatically increases when prices fall. But fears of debt deflation seem overblown: because nominal interest rates are themselves close to zero, the real burden of debt would not increase even if prices remained stable. Moreover, the manageability of debt service depends mainly on whether incomes increase faster than the outstanding debt, not on whether the inflation rate exceeds the interest rate.

This is especially important for highly indebted governments (and households). But on that score, the picture is currently even more positive: nominal GDP growth in the eurozone remains around 3%, well above the interest rates on almost all member governments’ longer-term debt (the average refinancing cost across the eurozone is now close to zero).

As a result, eurozone governments are in a very comfortable position. Provided they run a primary budget balance of revenue and non-interest expenditure, their debt burden will slowly decline, relative to GDP. Households are also favorably placed: their incomes are growing by about 3%, while mortgage rates are heading toward zero. They can therefore just wait for their debt-service capacity to improve over time.

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Central banks’ second reason for avoiding stable prices is that it might be difficult for prices to fall in absolute terms. In any economy, the relative prices of goods and services need to adjust in response to supply and demand shocks. So, for average prices to remain unchanged overall, some prices would still have to increase, and others would have to fall.

True, producers rarely face significant barriers to lowering the prices of most goods and services sold to consumers or other businesses. But firms generally find it much harder to reduce nominal wages to compensate for lower prices. It is better, therefore, for average wages to increase, so that those wages that need to fall do so in relative rather than absolute or nominal terms.

Yet the downward stickiness of wages is unlikely to become a concern anytime soon. Nominal wages are currently increasing by around 2.5% per year in the eurozone (and by over 3% in the US). These rates are among the highest this decade, which has been a period of strong employment growth overall.

Some may argue that average eurozone wage growth of 2.5% is not enough, and that the ECB’s expansionary monetary policy stance is thus justified. But the question remains: Should the ECB be preparing additional stimulus measures when the risk of harmful deflation is actually falling?

Moreover, downward wage stickiness can disappear, as the experience of Japan shows. In 2018, for example, Japanese wages increased by about 2%, the highest rate in over 20 years. But over the past 12 months, they have suddenly started to fall, even though labor-market conditions have not deteriorated. On the contrary: employment continues to increase and unemployment is still falling.

This is not the first time that wages have fallen in Japan, and previous episodes caused no noticeable problems. Some economists, in fact, have argued that downward wage flexibility does not seem to be a primary contributing factor to Japan’s prolonged deflation.

Central bankers today are thus facing a luxury problem: prices are increasing a bit more gently than they would like. Although inflation is below target, unemployment keeps falling to record lows, and debtors are happy. The need for occasional reductions in nominal wages seems remote in Europe and the US, and does not seem to cause trouble in Japan.

Given all this, it is hard to understand why the ECB in particular should be so anxious to find new ways to make its stance even more expansionary. Yes, economic activity has weakened over recent quarters, and survey-based indicators suggest that the global economy is poised for a slowdown. But as former US Secretary of the Treasury Lawrence H. Summers and Anna Stansbury have convincingly argued, by itself, further monetary-policy easing will do little to stimulate demand and drive inflation.

The ECB should tone down its rhetoric about the imminent risk of deflation and keep its course steady. Its hyper-vigilance about falling prices is misplaced, and its ability to increase the rate of inflation is dubious.

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