Complications of Low Inflation

by on November 14, 2013 4:10 pm GMT

From America to Europe, inflation is sinking, and it doesn’t matter what central banks are doing. The average inflation rate in developed economies is 1.5 percent and down from 2.2 percent in 2012. The drop in consumer prices is most dramatic in the eurozone with the latest inflation data reporting a .7 percent rate in October. Great Britain’s consumer prices dropped from 2.7 percent to 2.2 percent, down .3 percent from analyst estimates. In many cases, this has to do with the decline in commodity prices, largely due to sinking energy costs. However, even if energy prices were excluded, the eurozone core CPI would only be .8 percent, the lowest since the euro’s inception.

Consumer prices in the United States are declining, too. Inflation in September was 1.2 percent and under the Federal Reserve’s two percent annual target. The core CPI, ex-energy, remained at a low 1.2 percent.

The low-inflation environment is sparking debate on whether deflation will arise in the two largest economies in the world, the US and the eurozone (as a whole). Japan knows the dread of deflation, which just came out of a 15-year deflationary period.

This is catastrophic to high-debt economies. In both the United States and the eurozone, Japan as well, wages have budge little, if at all. Stagnant or falling wages and prices increase the hardships of paying debt. Consumers become accustom to falling prices and prolong purchases in hopes on prices continuing to decline. In the US, 70 percent of the economy depends on consumer spending.

What we are seeing now is low inflation that is undermining the ability for central bankers to bolster the economies and prevent another recession. Due to the decreasing inflation, central bankers are cutting rates opposed to increasing them during normal periods of growth. However, it is now becoming increasing difficult to combat this because interest rates are at all-time lows.

As rate reduction becomes an obsolete tool, central bankers are going to unconventional methods to promote growth, including quantitative easing. Some economists believe on ongoing money printing will cause inflation, but it has not. The Federal Reserve is currently indulging into a $85 billion monthly purchasing program and inflation remains at low levels.

The Federal Reserve could go on the same path as the BoE and ECB in regards to offering “forward guidance” in order to guide expectations over the short- and mid-term outlook. They could talk the markets into calmer water, if it were. The Fed could also lower target inflation expectations, but this would assume consumer prices would rise to over take the target.

Nevertheless, the chairwomen nominee has a bumpy road ahead of her, and it is still uncertain whether or not the global liquidity dump will spur inflation, or even hyperinflation. However, the current problem of stagflation – or deflation in the eurozone – is the current monster to slay.