Central Banks Shouldn't Fight Deflation

Authored by Frank Shostak via The Mises Institute,

Currently we can observe a general slowdown in the annual growth rate in price inflation across major countries around the world. For instance the yearly growth rate of the US consumer price index (CPI) fell to 1.5% in February from 1.6% in January and 2.2% in February last year. In Europe, the yearly growth rate of the EMU CPI stood at 1.5% in February versus 1.4% in January and 2.3% in October 2018.

The annual rate of China’s CPI has also eased in February falling to 1.5% from 1.7% in January and 2.9% in February the year before.The growth momentum of the UK CPI also displays softening with the yearly growth rate standing at 1.8% in February against 2.1% in the month before and 3% in January 2018.

Most commentators are of the view that deflation generates expectations for a decline in prices. As a result, it is held, consumers are likely to postpone their buying of goods at present since they expect to buy these goods at lower prices in the future. This weakens the overall flow of spending and in turn weakens the economy.

Hence, such commentators believe that policies that counter deflation will also counter the economic slump.For many commentators and economic experts to counter a decline in the annual growth of the CPI, which they fear could develop into a general decline in prices; they advocate that central banks should maintain a very loose monetary stance. For these experts a possible decline in prices — which they label as deflation — poses a major threat to the economy.

It would appear that if deflation leads to an economic slump then policies that reverse deflation should be good for the economy. Reversing deflation will simply involve introducing policies that support general increases in the prices of goods, (i.e., price inflation). By this way of thinking, inflation could actually be an agent of economic growth.

According to most experts, a little bit of inflation can actually be a good thing. Mainstream economists believe that inflation of 2% is not harmful to economic growth, but that inflation of 10% could be bad for the economy.

Why should a rate of inflation of 10% or higher be regarded as a bad thing? If anything at inflation rate of 10% it is likely that consumers are going to form rising inflation expectations, and according to popular thinking, in response to a high rate of inflation, consumers will speed up their expenditure on goods at present, which should boost economic growth. Clearly, there is a problem with the popular way of thinking.

Inflation Is not Essentially a Rise in Prices

Inflation is not about general increases in prices as such, but about the increase in the money supply. As a rule, the increase in money supply sets in motion general increases in prices. This, however, need not always be the case.

The price of a good is the amount of money asked per unit of it. For a constant amount of money and an expanding quantity of goods, prices will actually fall. Prices will also fall when the rate of increase in the supply of goods exceeds the rate of increase in the money supply.

For instance, if the money supply increases by 5% and the quantity of goods increases by 10%, prices will fall by 5%.

A fall in prices however, cannot conceal the fact that we have inflation of 5% here because of the increase in money supply.

The reason why inflation is bad news is not of increases in prices as such, but because of the damage inflation inflicts to the wealth-formation process. Here is why.

The chief role of money is to fulfill the role of the general medium of exchange. Money enables us to exchange something we have for something we want. Before an exchange can take place, individuals must have something useful that they can exchange for money. Once they secure the money, they can then exchange it for the goods they want.

Now, consider a situation in which money is created out of "thin air." This new money is no different from counterfeit money. The counterfeiter exchanges the printed money for goods without producing anything useful. He in fact exchanges nothing for something. He takes from the pool of real goods without contributing to the pool.

The economic effect of money that was created out of thin air is the same as that of counterfeit money — it impoverishes wealth generators.

The money created out of thin air diverts real wealth towards the holders of new money. This weakens wealth generators ability to generate wealth and this in turn leads to a weakening in economic growth. Note that as a result of the increase in the money supply what we have here is more money per unit of goods, and thus, higher prices.

What matters, however, is not price rises as such but the increase in money supply that sets in motion the exchange of nothing for something or "the counterfeit effect."

The exchange of nothing for something weakens the process of real wealth formation. Therefore, anything that promotes increases in the money supply can only make things much worse.

Changes in prices are just a symptom, as it were, and not the primary causative factor. So, countering a falling growth momentum of the CPI by means of loose monetary policy (i.e., by creating inflation) is bad news for the process of wealth generation and hence for the economy.

Moreover, in order to maintain their lives and wellbeing, individuals must buy goods and services in the present. Therefore, from this perspective, a fall in prices as such cannot be bad for the economy.

Furthermore, if a fall in the growth momentum of prices emerges on the back of the collapse of bubble activities in response to a softer monetary growth, then this should be seen as good news. The less non-productive bubble activities the better it is for the wealth generators and hence for the overall pool of real wealth.

Likewise, if a fall in the growth momentum of the CPI emerges because of the expansion in real wealth for a given stock of money, obviously this is great news since more people could now benefit from the expanding pool of real wealth. We can thus conclude that contrary to the popular view, a fall in the growth momentum of prices is always good news for the wealth-generating process and hence for the economy.