Reporters continually discuss deflation as though something magical will happen if the rate of price growth crosses zero and turns negative. This is silly. The point is that a lower rate of inflation raises real interest rates at a time when we want lower real interest rates. We can’t lower nominal rates below zero, so any decline in the inflation rate right now is bad news.
In this sense, 0.5 percent inflation is worse than 1.5 percent inflation. The situation gets still worse if this goes to a negative inflation rate of -0.5 percent. But the drop from 0.5 percent to -0.5 percent is no worse than the drop from 1.5 percent to 0.5 percent.
This is important to understand because the fixation on deflation implies that somehow everything is okay as long as our inflation rate is still positive. That is not true: the economy is suffering from an enormous output gap leading to tens of millions of people needlessly facing unemployment or underemployment.
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of False Profits: Recovering from the Bubble Economy. He also has a blog Beat the Press, where he discusses the media’s coverage of economic issues. This article was first published by CEPR’s Beat the Press blog on 10 August 2010 under a Creative Commons license.