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Facing the Deflationary Threat

Many central bankers are like the proverbial general who plans to fight the last war. But unlike backward-looking military strategy, flawed monetary policies produce inevitable damage, not merely worrisome risks.

Despite having conquered inflation, central bankers continue to fight it and as a result may fail to confront the latest economic menace - global deflation . Falling prices have paralyzed Japan's economy for a decade. China and Hong Kong have seen prices plummet recently too. As the world's richest nations gather in Canada for the annual G-7 jamboree, their leaders should ask if the US and Europe face a similar fate.

Deflation should not be hard to check, with sound policy. Some argue that rapid productivity gains from new technology, increased competition due to globalization, and the rise of internet-based electronic commerce created a world in which firms must steadily lower prices. But this thinking is based on a fallacy. Clearly, economic forces other than a country's monetary policy determine the relative prices that different goods and services should have - and which they eventually do have, regardless of monetary policy. These forces do not determine the absolute price (in dollars, say) of any good.

The absolute price of any good is determined by monetary policy, in a way largely independent of the structure of relative prices. The only exception is when monetary policy is conducted in a manner that focuses on the prices of particular goods rather than on stabilization of a broad price index.