The deflation dilemma

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The deflation dilemma

Rich countries must act to prevent prices from falling. That will cause problems for emerging economies

Jun 3rd 2010 | From The Economist print edition

SHOULD you fret more about inflation or deflation? Few questions matter more for investors and policymakers, yet few seem so uncertain. Financial markets are sending mixed signals. Falling yields on Treasury bonds suggest that many investors worry about economic stagnation and deflation; the soaring price of gold points to fears of runaway inflation.

Economists also differ in their assessment of where the greater risks lie, depending largely on the country and time frame they are looking at. Judging by the discussion in a new online forum of more than 50 leading economists from around the world, which The Economist launched this week, deflation is the bigger short-term danger in big, rich economies, whereas inflation is an immediate worry in many emerging economies and, potentially, a longer-term danger in rich ones.

That seems a fair assessment. In America, the euro area and Japan, deflation is either uncomfortably close or a painful reality, despite near-zero interest rates and other efforts by central banks. In the year to April core consumer prices rose by a mere 0.9% in America, the slowest pace in four decades. In the euro area they rose by 0.7%. And in Japan, which has battled falling prices for more than a decade, they fell by 1.5%.

Nor is there much reason to expect a sudden turnaround. Broad measures of money and credit growth are stagnant or shrinking in all three places. Unemployment is high and there are large gaps between the economies’ actual output and their potential. In the euro area, especially, austerity plans will further sap domestic demand. Thankfully, there is unlikely to be a sudden price plunge, not least because ordinary people still expect consumer prices to rise modestly, and these expectations of future inflation help anchor actual prices. But the short-term balance of pressures clearly points downward.

So, too, does the balance of risks. Deflation, if it becomes entrenched, is more dangerous than most forms of inflation. When prices fall consumers put off their purchases in anticipation of even greater bargains later, condemning the economy to a vicious cycle of weak spending and sliding prices. In heavily indebted economies falling prices would increase the real burden of consumers’ and governments’ debts.

Deflation is also harder to fight than inflation. Over the past two decades central bankers have gained plenty of experience in how to conquer excessive price increases. Japan’s ongoing inability to prevent prices falling suggests the opposite task is rather less well understood. Although it is true that heavily indebted governments might be tempted to erode their debts through higher inflation, there are few signs that political support for low inflation is waning (see article).

Add all this together and the world’s big three central banks—in America, the euro zone and Japan—should worry most about falling prices. The scale of budget belt-tightening suggests these banks’ policy rates could stay way down for several years. But this will cause problems elsewhere. Near-zero interest rates in the big, rich economies send capital flooding elsewhere in search of higher yields, making it harder for the healthier countries to keep their economies stable.

Helps here, hurts there

The problem will be most acute in emerging economies. Many are already overheating, with prices rising and asset bubbles inflating. Most have inappropriately loose monetary policy. Real interest rates are negative in two-thirds of the 25 emerging economies tracked by The Economist. Their inflation expectations are less stable, so prices can quickly spiral upwards.

This suggests a need for tighter monetary policy. Central banks in Brazil, Malaysia and elsewhere have begun. But the most important emerging economy, China, pegs its currency to America’s dollar, which limits its ability to raise interest rates. And even those with more flexible exchange rates worry that higher interest rates will send their currencies soaring.

In fact, stronger currencies in emerging markets are a necessary part of the “rebalancing” of the global economy that will allow enfeebled rich economies an escape from deflationary pressure. Tighter fiscal policy in emerging economies would help dampen price pressure. Capital controls should be part of their defences, too, against sudden floods of foreign cash.

History suggests, however, that none of these policies will be a panacea. When monetary conditions in the rich world are loose, emerging economies are prone to lending binges and asset bubbles. The price of avoiding deflation in the rich world today may be a bust in the emerging world tomorrow.

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