Too little inflation can be a problem too…

We’re very used to the idea of monitoring inflation, measuring it, and worrying about the consequences of it. But like any good answer that requires an element of balance, it’s worth noting that too little inflation can be a problem too.

According to the Economist, when central banks adopted “quantitative easing” (printing money to buy financial assets) and other weird and wonderful means to supported economies damaged by the financial crisis, many feared that the result would be out-of-control inflation. Asset prices have certainly soared. But consumer prices have not. Indeed, the growing fear is that rich countries may be entering a twilight zone of ultra-low inflation.

Everywhere you look in the rich countries, inflation is currently headed downwards.

One bright spot that has helped to keep G7 inflation from falling further is Japan, where expansionary policies are stoking hopes that the past decade and a half of deflation may at last be coming to an end.

Overall inflation has risen to 1.1%—higher than in the euro area—and core inflation is now at zero. But the immense difficulty that successive Japanese governments have encountered in trying to escape the shackles of deflation serves as a warning of the danger of letting inflation fall too low.

Once people start to anticipate declining rather than rising prices, it can be very hard to reverse their expectations.

Very low inflation in the euro zone makes it much more difficult for uncompetitive countries, predominantly in southern Europe, to regain lost ground. Workers tend to resist nominal cuts in pay more fiercely than they do the subtler erosion of their income through inflation.

If inflation in the countries with which the weak economies trade is high, they can improve their competitiveness simply by keeping their rate lower. That is in essence how Germany gained a big edge in the first decade of the euro. But with overall inflation so low, peripheral countries must instead adjust through outright deflation or something close to it, meaning a freeze or absolute cuts in wages. Already, in September, when euro-wide inflation was 1.1%, prices were falling by 1% in Greece. They were flat in Ireland and rising by just 0.3% in Portugal.

A sustained period of deflation would be particularly hard on the euro zone’s periphery, weighed down by debt. Cyprus, Ireland, Portugal and Spain have high public and private debt; Greece and Italy have high public debt. When prices are falling, debt, which is fixed in nominal terms, becomes more onerous in real terms. Higher inflation, in contrast, makes escaping heavy debt much less burdensome.

UK inflation finally falls back to target level (Jan 2014)

Test your understanding on inflation