The rate of inflation is now close to zero in the US and several other major countries. The Economist recently reported that economists it had surveyed predict that consumer prices in the US and Japan will actually fall this year as a whole, while inflation in the euro zone will be only 0.6 percent. South Korea, Taiwan and Thailand will also see declines in consumer price levels....and In- :
Deflation is potentially a very serious problem, because falling prices — and the expectation that prices will continue to fall — would make the current economic downturn worse in three distinct ways.
The most direct adverse impact of deflation is to increase the real value of debt. Just as inflation helps debtors by eroding the real value of their debts, deflation hurts them by increasing the real value of what they owe. While the very modest extent of current deflation does not create a significant problem, if it continues, the price level could conceivably fall by a cumulative 10 percent over the next few years.
If that happens, a homeowner with a mortgage would see the real value of his debt rise by 10 percent. Since price declines would bring with them wage declines, the ratio of monthly mortgage payments to wage income would rise.
In addition to this increase in the real cost of debt service, deflation would mean higher loan-to-value ratios for homeowners, leading to increased mortgage defaults, especially in the US. A lower price level would also increase the real value of business debt, weakening balance sheets and thus making it harder for companies to get additional credit.
The second adverse effect of deflation is to raise the real interest rate, that is, the difference between the nominal interest rate and the rate of “inflation.” When prices are rising, the real interest rate is less than the nominal rate since the borrower repays with dollars that are worth less. But when prices are falling, the real interest rate exceeds the nominal rate.
So the potential inflationary danger is that the large US fiscal deficit will lead to an increase in the supply of money. This inevitably happens in developing countries that do not have the ability to issue interest-bearing debt and must therefore finance their deficits by printing money. In contrast, when deficits do not lead to an increased supply of money, the evidence shows that they do not cause sustained price increases...
But now the large US fiscal deficits are being accompanied by rapid increases in the money supply and by even more ominous increases in commercial bank reserves that could later be converted into faster money growth. The broad money supply (M2) is already increasing at an annual rate of nearly 15 per cent. The excess reserves of the banking system have ballooned from less than $3bn a year ago to more than $700bn (€536bn, £474bn) now.
The money supply consists largely of government-insured bank deposits that households and businesses are holding because of a concern about the liquidity and safety of other forms of investment. But this could change when conditions improve, turning these money balances into sources of inflation.
The link between fiscal deficits and money growth is about to be exacerbated by “quantitative easing”, in which the Fed will buy long-dated government bonds. While this may look like just a modified form of the Fed’s traditional open market operations, it cannot be distinguished from a policy of directly monetising some of the government’s newly created debt...
The deep recession means that there is no immediate risk of inflation. The aggregate demand for labour and goods and services is much less than the potential supply. But when the economy begins to recover, the Fed will have to reduce the excessive stock of money and, more critically, prevent the large volume of excess reserves in the banks from causing an inflationary explosion of money and credit.