The Deflation Bogeyman

CAMBRIDGE – The world's major central banks are currently obsessed with the goal of raising their national inflation rates to their common target of about 2% per year. This is true for the United States, where the annual inflation rate was -0.1% over the past 12 months; for the United Kingdom, where the most recent data show 0.3% price growth; and for the eurozone, where consumer prices fell 0.6%. But is this a real problem?

The sharp decline in energy prices is the primary reason for the recent drop in the inflation rate. In the US, the core inflation rate (which strips out changes in volatile energy and food prices) was 1.6% over the last 12 months. Moreover, the US Federal Reserve, the Bank of England, and the European Central Bank understand that even if energy prices do not rise in the coming year, a stable price level for oil and other forms of energy will cause the inflation rate to rise.

In the US, the inflation rate has also been depressed by the rise in the value of the dollar relative to the euro and other currencies, which has caused import prices to decline. This, too, is a “level effect," implying that the inflation rate will rise once the dollar's exchange rate stops appreciating.

But, despite this understanding, the major central banks continue to maintain extremely low interest rates as a way to increase demand and, with it, the rate of inflation. They are doing this by promising to keep short-term rates low; maintaining large portfolios of private and government bonds; and, in Europe and Japan, continuing to engage in large-scale asset purchases.