United States Must Preempt Deflation

April 16, 2014

Deflation is a threat that needs to be taken seriously, says John Makin, a resident scholar at the American Enterprise Institute.

Deflation is a severe problem, and once it occurs, an economy is in for a tough ride. As such, policymakers must act preemptively and strike to deal with deflation before it becomes a major issue. Inflation indices have been falling in the United States, as well as in China and Europe, all of which have experienced more inflation than forecasted by experts. The U.S. government needs to act now to deal with this threat.

The Federal Reserve, in recent months, has taken the position that the United States' move toward deflation is only temporary, assuming that inflation, which has dropped below 1 percent, will soon move back toward 2 percent. This assumption is dangerous. Similarly, neither the European Central Bank nor the Chinese have taken efforts to slow deflation. Why this complacency?

  • Policymakers at the Federal Reserve, International Monetary Fund and European Central Bank argue that their "measures of expected inflation are well-anchored."
  • This is unwise, and once deflation does hit, it will be too late to avoid it -- history has shown this. When Japan slid into deflation in 1994, JPMorgan Chase said, "What is striking...is that no one seemed to be expecting it." Furthermore, it reported, "When deflation was getting under way, the OECD anticipated positive inflation through the end of the forecast horizon."
  • In addition, leaders contend that inflation that sits between 0 percent and 2 percent is unlikely to experience abrupt changes. There is little evidence for this claim.

Deflation is self-reinforcing, because when prices fall it reinforces the desire of households and firms to hold onto cash -- they can earn investment returns by doing nothing with their money. So when deflation appears, it tends to accelerate.

Policymakers must combat this threat before deflation takes hold.

Source: John H. Makin, "Now Is the Time to Preempt Deflation," American Enterprise Institute, April 2014.

 

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