Deflation means a fall in prices (a negative inflation rate). Policy makers should generally be concerned if there is an inflation rate of less than the target of 2%.
For example, in the Eurozone Jan 2015, the headline inflation rate is -0.2%. Even if we strip away volatile prices like oil, core inflation is 0.8%. This is a very low rate of inflation.
There are many serious potential problems of low inflation / deflation
- Higher debt burdens,
- Decline in spending,
- Higher unemployment.
See costs of deflation for more detail.
What options are available to overcome deflation?
The traditional tool of monetary policy is interest rates. If inflation is too low, the Central Bank can try to cut interest rates. In theory, this should boost spending and aggregate demand. For example, lower rates reduce cost of mortgage payments, giving people more to spend.
However, there are times when cutting interest rates are not sufficient. In a liquidity trap – zero interest rates may not encourage sufficient spending. For example, after the credit crunch – lower interest rates failed to boost demand sufficiently. Lower interest rates failed to solve low inflation for many reasons:
- People preferred to save,
- People took opportunity to pay off debts
- Banks didn’t want to lend, so firms couldn’t get loans despite low rates
- Banks didn’t pass the full base rate cut onto consumers.
Unconventional monetary policy
With a failure of interest rates, the traditional tool of monetary policy, Central Banks have need to consider unconventional monetary policy. Some of these policies are relatively untried.
Helicopter drop – print money
In theory, creating inflation should be the easiest thing – just print money and according to the quantity theory of money – we should get inflation. A particular policy for printing money is termed the ‘helicopter drop’ – where the Central Bank gives newly created money to consumers directly. Central Banks have been reluctant to pursue this strategy, presumably because it goes against the mentality of serious Central Bankers and their inflation fighting credentials. But, it would be a solution to deflation. The most challenging aspect would be knowing about much money to print, to get the right amount of inflation.