Good luck finding even a whisp of inflation in the above chart. Heck, if we all didn’t know that America was destined to again experience the scourge of rapidly rising prices thanks to the Fed’s supposedly easy money policy, that chart might suggest deflation is the bigger threat.
And why would this be a bad thing? In a new AEI paper, economist John Makin outlines several negative impacts: a) an increase in real interest rates, which would discourage investment and spending; b) an increase in the demand for cash, and a decline in the demand for goods; c) a rising real debt burden; d) even weaker job growth. And as Makin explains, “Once an economy slips into deflation, the risk of a self-reinforcing deflationary spiral rises.”
And here are his suggestions for avoiding deflation (bold mine):
First, the Fed should temper its complacency about the possibility of further disinflation and deflation. If disinflation persists and the Fed’s favorite inflation measure, the core personal consumption expenditures, drops below 1.0 percent (it is currently at 1.2 percent), then the Fed should restate the desirability of boosting inflation and underscore efforts to achieve that goal. Perhaps signaling a possible increase in QE rather than another hint of tapering will be required.
Second, the Fed could underscore its desire to avoid deflation by setting a new target range for inflation with a firmly defined lower bound. Currently, the Fed talks about a 2 percent inflation target, with any significant rise above that level leading to Fed tightening. The Fed would do well to reinforce the symmetry of its goal with respect to the behavior of inflation. The Fed could highlight its long-run commitment to avoid inflation, along with its desire to avoid deflation, by specifying a target range of around 0.5 to 1.5 percent for inflation. With that target range, a drift of inflation below the 1 percent level would lead to increasing emphasis by the Fed of its commitment to avoid deflation. While inflation expectations have been sticky, a further drift toward disinflation could cause a sudden change in expectations in the deflationary direction. That would constitute a substantial drag on economic growth and a threat to global economic expansion.
Yellen’s elevation to the chairmanship of the Fed, probably during the first quarter of next year, presents the Fed’s third opportunity to underscore its commitment to avoid deflation. Yellen should resist the temptation to sound hawkish in view of her, probably unwarranted, reputation as a dove on inflation. She knows the risks of inflation and ways to deal with it. By discussing the risk of deflation at some length and by putting a firm floor on the Fed’s willingness to tolerate a drift toward deflation, Yellen could substantially reduce the risks that fears of deflation could produce. Avoiding a self-reinforcing deflationary spiral should be a clearly articulated objective of the Yellen Fed.
Clear and forceful Fed communication would be a helpful first step — though not as helpful, of course, as policy rule (like targeting the path of nominal GDP) that addressed both sides of the central bank’s employment-inflation.
Follow James Pethokoukis on Twitter at @JimPethokoukis