The Edgy Optimist

Deflating Expectations

Economists have inflation on the brain, but they’re missing the point.

Federal Reserve Chairwoman Janet Yellen during commencement ceremonies for New York University.
Federal Reserve Chairwoman Janet Yellen, pictured  during commencement ceremonies for New York University on May 21, 2014, has other things to worry about than inflation.

Photo by Andrew Burton/Getty Images

In a Reuters poll out this week, most economists say they are expecting more robust inflation this year, to the tune of 2 percent. The poll accurately reflects the plethora of emails from research firms in my inbox—a slowly building chorus predicting rising prices along with an uptick in overall economic activity.

But this view fundamentally misses the nature of economic activity in the world today—namely, that we are, all of us, in the midst of a protracted period of stable prices verging on deflation. The challenge of the last century may have been inflation; the challenge of this one, at least so far, is sharply different.

First, inflation at a rate of 2 percent is only “inflation” in the sense that it is higher than the 1.5 percent it was last year in the U.S., according to the Consumer Price Index released each month by the Bureau of Labor Statistics. It is also higher than what many had assumed it would be at the beginning of the year. But a 2 percent increase is not really “inflation” in any meaningful way. In fact, at 2 percent, prices are increasing at a slower rate compared with all but nine of the past 50 years.

In a healthy economic system that relies on both growth and some dynamic change, you want modest inflation. But because of the searing experience of sharp double-digit inflation in the 20th century, inflation is typically perceived as a danger. Hyperinflation in Weimar Germany is widely understood as paving the way for the Nazis and World War II. Runaway inflation in Latin America in the 1970s is seen as a cause of collapse and dictatorships. Double-digit inflation in the U.S. in the 1970s is remembered as a dark period of decline.

Yet those days are increasingly part of the distant past. Over the past 20 years, the official inflation rate in the U.S. has averaged below 3 percent. And it is not just the U.S. Inflation globally has been low and getting lower. In China the annual rate is falling rapidly from its annual average of close to 6 percent from the mid-1990s until last year, and now stands at less than 2.5 percent this year—and that for a country with a growth rate still in excess of 7 percent. In the European Union, the central bank headed by Mario Draghi is preparing to unveil some sort of stimulus in June because of concerns that deflation is hampering the very sluggish recovery. And in private conversations (or not so private, given that they have been reported), former Fed Chairman Ben Bernanke has been saying that he does not expect to see interest rates on the 10-year note to be above 4 percent again in his lifetime.

Talk of rising inflation this year is therefore beside the point. The current trajectory of the global economic system trends toward price stability verging on deflation. That is a dramatically different world than the one we have recently emerged from, namely a 20th-century world defined by industrial nation-states and closed financial systems where price shocks, volatility, and inflation posed ever-present threats that demanded vigilance.

The challenge today is that all of the institutions charged with guarding the stability of that system were created to combat inflation, not deflation. They weren’t created in a world where growth overall is muted and steady. The situation echoes that old adage: If you are a hammer, everything looks like a nail.

In an odd twist, the central banks seem to have the clearest recognition of the world as it is now—more so than economists in general or amid the public discussion in markets and media, where observers are quick to look for evidence of inflation when there isn’t any. But central banks have inflation-warrior DNA, which challenges their ability to confront deflation aggressively—much as the Pentagon, set up in the wake of World War II, finds it challenging to adjust to a world of nonstate actors and unconventional warfare.

There is, of course, the constant drum of conspiracy theory and deep-rooted conviction that official inflation numbers are consistently kept low to allow the government to depress Social Security and other payments tied to the Consumer Price Index. That has been a current for decades—at least since the late 1940s, when George Meany of the AFL-CIO accused the federal government of purposely distorting the inflation numbers to prevent unions from demanding higher wages.

Of course, an absence of inflation does not mean that wages are adequate to meet needs. In that sense, popular concerns about inflation are a manifestation of an acute anxiety about the mismatch between the incomes of many and their real cost of living. But the actual challenges are price stability and deflation. Wages aren’t going up in any meaningful way separate from benefits because there are so few price pressures—not in the U.S., not in Europe, and certainly not in Japan.

The global dimension matters more than ever. Everywhere in the world is seeing declining energy prices, declining commodity prices, and slower growth. Technology is generating radical efficiencies and lower costs. The only major economies seeing any noteworthy inflation—Brazil and India—both have very strict capital controls and governments focused on increasing living standards, and hence raising averages wages. Their inflation is not a systemic problem; it stems from active policy.

Inflation, the single greatest threat to economic stability in the 20th century, is rapidly receding as a risk. That’s the good news. The less good news is that we don’t have the institutions or the mindset to meet the great challenges of the early 21st century: deflation and stasis. Preventing inflation or offsetting it require one set of tools and attitudes: higher interest rates, less spending, tighter control of money. But those tools and the attitudes that come with them are useless bordering on destructive in the face of deflation and stability. Until economists stop looking for inflation and people stop fearing it, we will be hard-pressed to grapple with the world as it is and stop fighting the last war.