The Low-Inflation Trap (Slightly Wonkish)
Looking at recent numbers, I’ve realized that there’s something else to worry about, beyond all the usual concerns. Let me call it the low-inflation trap; it’s something we’re very, very close to getting into.
Usually we worry about a deflationary trap, which comes about as follows: suppose that the economy is depressed, that as a result prices begin falling, and interest rates are up against the zero lower bound. Then as deflationary expectations take hold, the real interest rate rises even as the nominal rate stays pinned at zero — and this rising real rate helps keep the economy depressed. Japan has been in this trap for a long time.
But here’s what I’ve been thinking: we don’t have to get all the way to actual deflation for something like this to take hold. The key point is that long-term interest rates, which are what matter for spending, are effectively bounded some ways above zero. The reason is option value: the short rate could move up, but it can’t go down, so the yield curve has to be upward-sloping. Indeed, Japan’s 10-year rate is still 1 percent even though the short rate has been zero for many years and is likely to stay zero for years to come. (Yes, this is Keynes on liquidity preference).
And you can make a pretty good case that the US 10-year rate would have a hard time moving much lower than it is now, even if people believe that we’re in full Lesser Depression mode.
What this means is that much of any further decline in expected inflation — which has plunged lately — will translate into a rise in real interest rates. And that will be a drag on the economy, leading to further inflation declines. Basically, we can get into the functional equivalent of a deflationary trap long before we reach actual deflation. And it starts around now.
Just trying to cheer everyone up.
http://www.cepr.net/index.php/blogs/cepr-blog/krugman-notes-that-low-inflation-is-a-problem
Krugman Notes That Low Inflation Is a Problem |  |
| Written by Dean Baker |
| Sunday, 25 September 2011 08:32 |
 For far too long economists and economics reporters have fixated on the prospect of deflation, as though something really bad happens if the inflation rate falls below zero and becomes negative. This is another one of the ungodly silly things that otherwise intelligent people are inclined to believe. Of course there is zero magic to zero. The problem is not a negative inflation rate per se, the problem is an inflation rate that is too low. Given the weakness of the economy, we would like a large negative real interest rate. The federal funds rate is zero, which is as low as it could go, and even the long-term rate is approaching its lower limits. (People holding long-term bonds at very low interest rates risk large capital losses if interest rates rise at some future point.) This means that to get the real interest rate down, we need to get the inflation rate up. One can dispute how large a negative real interest rate we would want (according to some measures of the Taylor Rule, it should be as high as - 6.0 percent), but the basic story is the higher the better. In this context a prolonged period of very low inflation is bad, even though a period of low deflation would be even worse. However, crossing zero is just a difference of quantity, not quality. There is no reason to be more upset about a drop in the inflation rate from 0.5 percent to -1.5 percent, than a drop from 1.5 percent to 0.5 percent. Krugman essentially makes this point in his blogpost yesterday. Hopefully this will help to end the obsession with deflation. The point being that everything is not okay as long as the inflation rate just stays positive. Some of us have been saying this for a while (e.g. here, hereand here), but it helps hugely to have Krugman making this point. |
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