Winner of the New Statesman SPERI Prize in Political Economy 2016

New! Lecture on 23rd May at Bush House, 44-46 Aldwych on my book 'The Lies We Were Told' with discussion from Rachel Shabi and Aeron Davis. Book here.

Thursday, 15 January 2015

Why below target inflation is a big problem

Much of the coverage of deflation seems to miss the key point. Deflation is a sign that resources are being wasted. The lower inflation is, other things being equal, the more resources are being wasted. Wasted resources are probably a bit economics speak. What it means is that society as a whole - you and I - are worse off for no reason. There are also good grounds for thinking the sums involved could be very large, dwarfing the numbers the media normally frets about. [1]

Once you look at it this way, lots of rather silly debates become clear. First and most obviously, there is nothing magic about the number zero. Other things being equal, zero inflation suggests more resources are being wasted than if inflation is 1%, but resources are still being wasted when inflation is 1% and the target is 2%.  

Economists have worried about some of the knock on effects that deflation might have. In particular, because deflation means that the real value of debts fixed in nominal terms is rising, that may induce debtors to cut back spending, with no matching increase in spending by creditors. This will make the waste of resources worse. However this effect is not a non-linear one that kicks in when inflation is zero. If this effect is important, debtors will still be more inhibited by their debt if inflation is 1% compared to 2%. And, of course, even if this effect is unimportant resources are still being wasted if inflation is below target.

This is also why looking at some measure of core inflation is important. If below target inflation is just due to lower oil prices, say, which in turn are just lower because of increased supply, say, [2] then this is no reason to think resources are being wasted. Just as inflation targeting central banks should largely see through any inflation caused by higher oil prices, they should also do the opposite. However in the UK, US and Eurozone core inflation is significantly below target, suggesting resources are being wasted everywhere.

The really interesting thing about the current situation is that in all three places nominal wages seem to be going nowhere fast. This could be partly because plenty of domestic spare capacity exists, but partly also because workers are aware of the potential employers have to use overseas labour as an alternative. In either case, the really good news that this implies is that we can allow the economy to grow at an above average rate for some time. (It also suggests that current fiscal projections may be too pessimistic.)

This is only good news if we take the opportunity it presents. We should use the monetary and fiscal tools we have at our disposal (and invent some new ones if need be) to do so. There is no magic to raising demand - we have various tried and tested means of doing so. The basic barrier to raising demand has been and always will be inflation, so when that barrier is nowhere in sight (in fact appears to be moving further away) it is a criminal waste not to expand demand.

But what of those who advocate caution. We should raise interest rates now, so as to avoid rapid increases later? I am sure some people who argue this way are genuine, but just wrong because they have not realised the implications of the position we are now in, and in particular the balance of risks involved. But I cannot also help noticing that some on the right have been arguing for higher interest rates for some time, and refuse to admit they were wrong. They are confirming Kalecki’s idea that although what he called full employment was good for society, it may not be good for some particular parts of society. Those pursuing this line should not be dismissed: they should be laughed into obscurity.   

[1] This would be clearer if all central banks had a dual mandate.

[2] Which in the current situation is probably not true, so this is just to make the point.


  1. "Other things being equal, zero inflation suggests more resources are being wasted than if inflation is 1%, but resources are still being wasted when inflation is 1% and the target is 2%. "

    I am genuinely perplexed by this.

    By the way you have phrased the opening paragraphs the claim *appears* to be that the lower inflation is the more resources are being wasted. So, the conclusion ought to be that, other things being equal, we ought to aim to have inflation as high as possible to prevent waste.

    If inflation at 1% inhibits debtors from spending, then the logical conclusion seems to be that we should aim to make inflation as high as possible (all other things being equal) in order to encourage them. Wiemar here we come.

    I don't think that can be quite right, and I am sure it is not what you mean.

    Another reading is that resources are wasted when inflation is below target. But why? Why is a target of 2% less wasteful than one of 1% or 25%? Without more I don't know. 2% cannot be the 'right' figure just because it is the target. The target is just the figure posited by a figure in authority, it could be anything. We need some further analysis of what the optimum level is in order to know whether 1%, 2% or 25% is too low or too high.

    I had expected something on the problem of sticky prices, but that can't alone be used to calculate what the optimum level of inflation is (which I suspect is actually incalculable).

    Those who argue that 1% is not much to worry about would also point to the long period preceding the recent fall when we were above target as being a partial justification. There must be some force in this.

    In order to be polite, let me assure you that I completely agree with the last paragraph.

    1. Spinning Hugo

      You are indeed very polite.

      Kaleckian conspiracy theories are beyond rational discourse.

    2. If I can piggyback on Spinninghu's comment, doesn't long-run money neutrality suggest that even low inflation should carry us along a stable real growth pathway so long as the low inflation is anticipated? I thought that the Great Depression and Great Recession were impacted by the failure to defend nominal pathways from plunging to, or below, zero. Hypothetically, shouldn't we expect that a credibly defended 1% to 2% PCE channel would eventually support the same real growth as a more inflationary regime?

    3. SH: This is not about what the inflation target should be. The inflation target is 2%. That should anchor expectations. Given that, why would core inflation be below 2%? Because there is a negative output gap. That is just a shorthand way of saying that if output was higher (the gap was zero) core inflation would be on target. It is that simple.

      Anon: I must admit when someone suggested the Kalecki story to me as an explanation for certain policy positions a couple of years ago I too thought it far fetched. But I am fast running out of plausible alternative explanations!

      A: If I get your comment, you are right that below 2% inflation could just indicate that the 2% target is not credible. However before that happened we should see a prolonged period where 2% is believed but a negative output gap means actual inflation is below target. That is where I think we are now.

    4. Anon,

      No, you are right, I was bending over backwards too far.

    5. "This is not about what the inflation target should be."

      But, unfortunately, in order to make good the proposition that "below target inflation is a big problem" you have to answer that question, don't you? If it could be shown that the target was wrong, and ought to be 1% (and I am not arguing that) then missing it would be a good, not a bad thing.

      2% is, in my view, just a judgment call as to the right figure. Indeed, we are also making judgment calls over the timeframe over which the figure is measured. So if we have a monthly target of 2%, figures in Jan of 0%, Feb of 3% and March of 1% will all be off target. But if the timeframe is quarterly, then we may be more or less at 2%.

      So, at the moment. low inflation after a lengthy period above it, doesn't seem to me to be a source of great worry, unless we can come up with a reason why 2% really does matter other than that that is the number we plucked out of the air.

    6. No, I do not need to answer the question if the target is 2% and it is credible. Even if you think the target is 1%, but is actually 2% and credible, 1% inflation would be bad. If you want a lower target, you argue for a lower target. This is why Osborne's celebration of current inflation was economically illiterate. But he knew that, because he has economists advising him.

    7. "Even if you think the target is 1%" - I meant to write "Even if you think the target should be 1%"

    8. I think I see the force in that.

      So the primary argument is that the target ought to be met because it is the target. Whatever level we fix the target at, the more we miss it by the less credible it becomes, and so the less use it is going forwards in anchoring expectations as to what prices may be. Missing the target, whether above or below, is therefore a bad thing. There is merit in meeting the target (whatever it is, 1, 6 or 45) because there is merit in the expectation that targets will be taken seriously and met.

      A secondary and related argument is that if expectations fall below zero we can fall into deflation. That means we need a credible target above zero (whatever it may be) which everyone expects will be hit (whatever it is). Your fear is that we are now in the twilight zone before we go into the darkness of below zero.

      I think I'd accept both those arguments. So it really wouldn't matter for either of them whether the target was 1, 2, 3 or 6%.

      I would note however that these are not the kind of arguments you relied upon above the line (perhaps you took them as read). I'd also suggest that vast majority of people don't know what the target is, and so the value of the declared target in fixing expectations is probably pretty minimal. What the actual inflation rate really is has far more real world impact.

    9. Mainly Macro15 January 2015 at 02:51

      " I must admit when someone suggested the Kalecki story to me as an explanation for certain policy positions a couple of years ago I too thought it far fetched. But I am fast running out of plausible alternative explanations!"

      That tells us more about you than real life.

    10. If you want to convince anyone besides yourself, it would be better to provide some alternative explanations rather than making snide remarks.

    11. Two percent inflation target came out of thin air, just like the EU 3% deficit target. A "rule of thumb" is that at interest rates near zero for 3 month Bonds, the secondary market tends to add circa 2 % for long term Bonds.

    12. Even if hitting the target brings significant benefits, there is still the question is to what the optimum target is. Contrary to Anon’s claim, I don’t think the 2% comes out of thin air. I’ve always understood the argument for a small positive rate to be as follows. First, changes in the relative wage of different professions are desirable so as to equate supply and demand for different skills. Second nominal wages are sticky downwards. Ergo changes in relative wages are best brought about by RAISING the nominal wage paid to skills in short supply rather than by CUTTING the nominal wage for skills in surplus, and a small positive rate of inflation helps that process.

    13. Prof. Wren-Lewis:

      You write:

      " I must admit when someone suggested the Kalecki story to me as an explanation for certain policy positions a couple of years ago I too thought it far fetched. But I am fast running out of plausible alternative explanations!"

      In spite of your government work, your experience of life seems limited.

      Perhaps these references will help you:

      Robert Conquest’s Third Law of Politics:

      "The simplest way to explain the behavior of any bureaucratic organization is to assume that it is controlled by a cabal of its enemies."

      Of course, such a cabal does not exist. It was all well intended.

      So the solution comes from the German poet and intellectual Gottfried Benn:

      "Well meant is the contrary of well done."

      " I must admit when someone suggested the Kalecki story to me as an explanation for certain policy positions a couple of years ago I too thought it far fetched. But I am fast running out of plausible alternative explanations!"

    14. Mainly Macro15 January 2015 at 04:47

      Believers in conspiracy theories find it very snide when their beliefs are challenged.

    15. As my 74 year old mother says - inflation is the biggest theft of all. And anyone who is selling the notion that higher inflation is selling snake oil.

  2. But George seems to disagree with much of what you have written, particularly in relation to UK core inflation and nominal wages:
    "Core inflation, which strips out those factors, remains relatively stable and indeed rose slightly in yesterday’s data. Even more importantly, expectations about future inflation remain well anchored and the latest data show that earnings growth is accelerating not slowing down.”
    “Rising real incomes, a recovery spreading to all parts of our economy, and family budgets that can stretch that little bit further – let’s celebrate these effects of low inflation, not fear them."
    Plus it seems policy can deal with it without too much bother…
    "In the UK our system is well equipped to deal with negative inflation shocks just as it dealt with the surge in commodity prices in 2010 and 2011.”
    On a wider note, I wonder what you make of this from George – a direct reference to the evidence and experience of the past few years which seems at odds with what you have noted over the same period??:
    ”Pessimism has been fashionable in recent years, whether it's predictions of secular stagnation or claims that the proceeds of growth would only go to the richest.
    ***“The problem for the pessimists is that the evidence and experience of the last few years increasingly don't support their claims.***
    ”Instead the case for optimism is strengthening. If we are willing to take on the vested interests and pursue the right policies with consistency and discipline then there are no limits to what Britain can achieve.”

    1. George Osborne, having presided over the worst recovery on record, will say anything if he thinks it might help him get reelected, even if it makes no sense in terms of the economics or statistics.

    2. Which is his right of course (free speech etc), but as you've stressed before, he shouldn't and wouldn't get away with it if many in the media were doing their jobs properly by checking what he is saying, rather than simple, unquestioning regurgitation. It is perhaps a depressing indicator of the current state of affairs that he feels he can so boldly state these falsehoods without fear of being corrected.

  3. If the recent change in inflation is (1) unanticipated; (2) a result of a negative cost push shock then it's similar to a transitory tax cut (actually, it's better than that, as a temporary tax cut implies higher taxes in the future. This is not true of changes in commodity prices).

    To see if the recent change in inflation really reflects persistent and negative output gaps, you could look at inflation expectations, e.g. the final chart here

    Not a lot of evidence that we have a lot of negative output gaps to look forward to in market prices

  4. "In particular, because deflation means that the real value of debts fixed in nominal terms is rising, that may induce debtors to cut back spending, with no matching increase in spending by creditors."

    Interesting hypothesis. Can you point to behavioural research that supports it?

    1. Er, liquidity constraints?
      Creditors tend to be less constrained than debtors. Otherwise they would usually not become creditors.

    2. Creditors are creditors because they have constrained themselves in the past. It is possible to argue that past behaviour is a predictor for the future, so creditors keep saving up. Your argument is also perfectly possible, so one can argue either way.

      That's why I'd like to see some actual behavioural research on what happens in the actual world.

    3. Er, no. Both arguments end up with no matching increase in spending by creditors. See also: decades of economics history.

    4. Oops, you're right, error of logic on my part. I still wonder how much consumers' buying decisions are influenced by inflationary expectations though. I sure haven't delayed a purchase because of low inflation.

    5. What about the housing market?!

  5. I saw Andrew Sentance making the case on BBC News 24 that 0.5% CPI means interest rates should be raised sooner rather than later.

    BBC News 24 also interviewed Arthur Laffer on autumn statement day.

    I think they should all get posts at the BIS.

  6. How is it with sectors of the economy that are in permanent deflation, such as electronics. While the prices of electronic gadgets (of the same quality) drops continuously (or actually what you get for your money increases continuously) people still buy gadgets.

    Is that again that inflation (deflation) being below the expectation is wasteful, but as long as people expect x% deflation in a certain sector it is okay to be a x%, but wasteful to have an even stronger deflation?

    1. It's just simple time preference, for a lot of goods consumption now has a premium over consumption in a future time period so a consumer would still consume the good provided the utility gained by consuming now is greater than the utility from future consumption plus any saving from lower prices.

  7. "If this effect is important, debtors will still be more inhibited by their debt if inflation is 1% compared to 2%."

    Surely what matters for debtors is their debt-to-income (particularly debt-to-permanent income) ratio, not the real value of their debts as such?

    I agree that we should have an AD stimulus to obtain a 4-5% NGDP growth path from 2008 onwards, but I don't base that on the fall in inflation, which seems to be a benign and one-time positive oil price shock. The main dangers seem to be (a) pressure for premature interest rate rises when inflation goes up again and (b) a simplistic association of low inflation/deflation IN GENERAL with this sort of economic condition.

  8. Since the nominal value of debt is fixed inflation reduces the real value of debt. Unless real income falls as much or more this improves the debt-to-income ratio. I'm not familiar with the details of how debt is handled in a permanent income model. My impression is that the story isn't much changed though it is stated in a more complicated way.

  9. Prof Wren-Lewis:

    Great post. One of the underrated features of NGDP targeting is that it's more robust to supply shocks than inflation targeting. Instead of tightening in the face supply shock (like a big increase in oil prices), the CB would allow a period of below-trend RGDP growth and above-trend inflation.

    In fact, I think it's this precise flaw in inflation targeting that led the Fed so disastrously off course in their decision not to cut rates. From the FOMC minutes on September 16, 2008 (the day after Lehman Bros. collapsed:

    "Inflation had been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations had been elevated. The Committee expected inflation to moderate later this year and next year, but the inflation outlook remained highly uncertain. Although downside risks to growth remained, the upside risks to inflation were also of significant concern to the Committee."

  10. Isn't lower inflation just an indication that more resources WERE probably wasted in the past? for example look at Spain, I can assure you that when you waste resources and mis-allocate capital everybody feels great.

  11. So, Simon, how are we supposed to tell the difference between resources that are "wasted" and deliberately left as margin for error when activity slackens? Like, say in the school system, where the presence of some spare places allows pupils to move more easily, and therefore working more efficiently overall.

    This is my beef about Germany, most often expressed in comments on FT editorials. The Germans seem to be more equable and less prone to hype than us, so when the global economy booms, they just run current account surpluses and ignore the jibes about being a drag, and then pass the hare during the busts, giving them a pretty good performance overall, with less stress.

  12. Simon: I come to the exact opposite answer to you. Funny thing is though, we don't actually disagree (much).

    Suppose you discover there's a supply of free lunches you didn't know about, and had been letting go to waste. You might kick yourself for having missed them, but it's still good news, because you can eat them in future.

    Of course, it's only good news if the BoE realises its mistake, and starts eating them.

    1. Nick: Yes, I read your post after writing mine and figured we were basically saying the same thing. The key is to do the things necessary to make it good news.

  13. Maybe "there is no magic to raising demand" but the ECB and the Fed sure seem to have opposing ideas of how to achieve their shared goal of raising demand. QE aside, the Fed sees higher wages and equality as essential. But the ECB's agenda, as well as that of the EMS & EC, is for more austerity and their structural reforms which pretty boil down to lower wages, limitations on the ability of the unions to represent wage earners and a reduced welfare state. It would seem the ECB and its allies perceive growing demand by reducing wages and benefits. It looks like growing demand through greater inequality, the exact opposite of the Fed. It seems unlikely that they are both right.

  14. Perhaps we need a job guarantee so resources are never wasted and unemployment is abolished forever Simon. Combine with Land Value Taxation to redistribute land.
    Everyone has a house and a job. :)


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