Question about inflation

[Silvie]

Today I read on a news website that inflation in Europe is really low: 0.5%, significantly lower than the expected 2%. So I thought: wow, that's great! Then I read on to find this:

The European Central Bank will probably announce measures stop the declining inflation.

Why would they do this? Isn't low inflation good? Does it have to do with trading, import and export with non-European countries?

[nereo]

Short answer:  A little inflation is good for the economy, while a lot of inflation is bad.  Deflation (when prices go steadily down) is generally horrible.

Here's the quick version why: when there is some inflation (say, 2%) it encourages businesses to spend that money instead of hoarding it as cash.  Say a company has to buy a new machine that costs $100,000.  If they wait a year to buy it at 2% inflation, they'll have to pay $102,000.  So there is an incentive to buy it now.  When companies spend money, things get built, workers have jobs, and the overall economy does well.

Also, inflation is great for everyone who has debt.  I currently have $15k in student loan debt that is in deferment (earning 0% interest). In two years I will owe less on that debt than I do now in real-adjusted dollars.  Great for me! 
Not only is it good for me, but it is great for governments that have national debts (almost every developed country).  If the US balanced its budget every year (it hasn't) and with the typical 2% inflation, then in a few decades our $14T debt would be almost meaningless.  Instead of paying down our debt we could let inflation just chip away at it.  Of course, we'd have to stop spending more than we bring in for taxes every year...

For these reasons the Fed has a congressional mandate of keeping inflation low (at ~2%).  Much higher than this or much lower than this is considered to be a drag on the economy.

Runaway inflation is of course very bad.  That's when inflation starts goes way up (sometimes it can go over 10%.)  When that happens there is a rush to spend as quickly as possible, since your purchasing power will go down very rapidly.  This leads to companies and individuals being less valuable every year.

Deflation is also a worry - when prices go down.  This happened to Japan in their "lost decade".  While prices getting cheaper may sound like a good thing, it creates a strong incentive for companies not to spend money, since they can grow simply by "doing nothing".  In essence, a company during deflation can grow simply by not hiring and not spending, which is bad for GDP and bad for employment.

[Silvie]

Thanks for your reply, I understand much better now!

[huadpe]

Just to hop on here: nereo is accurate but doesn't give a full picture of just how awful deflation is.

The big problem with deflation is that it ruins people and companies who have debt.

Suppose I have a factory that makes chairs, and my inputs of labour and wood and padding cost $80, and my chairs sell for $100.  And my factory makes 100,000 chairs a year, so I have a profit then of $2 million a year ($20x100,000).

Now, a factory is expensive to buy, so let's say I pay $1.5 million a year for my mortgage.  Profit after mortgage is $500k plus I am building equity in the factory.

Now we have a big deflation, say, 40%.  So my factory now has input costs of $48/chair, and sells each chair for $60.  At 100,000 chairs, that's $1.2 million in profit.  That would be ok, since the $1.2 million is worth more, except...my mortgage hasn't changed.  I am now $300k in the hole every year, and all my equity in the factory has been wiped out.  My factory is now likely to close, even though it should be able to be operated profitably.

[Silvie]

Thank you huadpe, good to have an example of how this works in practice.

[Hugerat]

I'd refine the discussion about inflation in that high(er) inflation isn't at all bad as long as it is in line with inflation expectations. Most people's experience with inflation comes from a misunderstanding of the '70s when prices rose because of supply shocks and a price-wage spiral (workers demanding more money because of rising prices, causing further price rises, etc.).

In theory at least, everyone in the economy adjusts their expectations and actions for expected inflation. If you had an expected inflation rate of, say 10% then workers would demand 10% or slightly higher annual raises, a typical rate on a mortgage might be 16 or 17%, you might earn 8% on a savings account, and even nominal stock prices would rise by an additional 10% a year. Everyone is happy in this scenario. Hyperinflation is actually a very well understood phenomenon, and central banks nowadays are pretty good at containing the price-wage spiral that occurred in the '70s (by engineering recessions).

Much of the discussion now is about how the typical targeted inflation rate of 2% is probably too low because when you have a big financial shock like the 2009 financial crisis you get very uncomfortably close to deflation and it is very hard to get out of. The expectation scenario I described doesn't happen because interest rates can't go below 0% and workers are very resistant to accept wage decreases. What huadpe describes is also spot on and deflation generally leads to lots of debt default, wiped out businesses and widespread unemployment. A target rate of, say, 4% or 5% might be better for avoiding something like the ongoing malaise.

[nereo]

Much of the discussion now is about how the typical targeted inflation rate of 2% is probably too low because when you have a big financial shock like the 2009 financial crisis you get very uncomfortably close to deflation and it is very hard to get out of. The expectation scenario I described doesn't happen because interest rates can't go below 0% and workers are very resistant to accept wage decreases

I've often wondered why people say that interest rates can't go below 0%.  In theory, couldn't the Fed decide to set interest rates at -0.25%?  Such a move would obviously be costly, as the Fed would be paying banks to take out loans, but under this scenerio that would plump up balance sheets and create a need to spend money, thus pulling an economy out of its deflationary death-spiral, no?  Obviously there's no precedent for doing this, but until recently there wasn't one for QE1 and QE2.

It seems like the hardest part about getting a 4 or 5% inflationary target is the public's resistance to increasing price changes.  People still talk about how, "in the good 'ol days before WWII gasoline cost $0.25/gallon", even though in real dollars its almost exactly the same price today.  "How expensive everything is nowadays" is a surefire conversation topic, even though the majority of everyday items costs the same or less today than it did 50 years ago.

[gobius]

I was in the same position as you, Silvie.  I thought deflation would be great until it was explained to me the same way these guys/gals are explaining it.

Bonds are worth more with deflation which is one reason why people like Jim Collins recommend holding them.  Someone described it with the chair factory.  If you're holding a government bond worth $50K and deflation hits, that $50K will be worth more and the coupons you are receiving are worth more, since they are a fixed dollar amount and dollars are worth more.  Not only that, but demand would probably go up for them.  If you rebalance a portfolio and see the deflation going away you could sell some of those bonds.  The issue is, as others said, whoever you lent the money could default.

[gobius]

It seems like the hardest part about getting a 4 or 5% inflationary target is the public's resistance to increasing price changes.  People still talk about how, "in the good 'ol days before WWII gasoline cost $0.25/gallon", even though in real dollars its almost exactly the same price today.  "How expensive everything is nowadays" is a surefire conversation topic, even though the majority of everyday items costs the same or less today than it did 50 years ago.

People who support a gold standard say similar things, on how the dollar is worth 5% of what it was worth when the Fed was created or something like that.  A dollar could buy you more things back then, but it could also buy more things from you (such as labor).

[jba302]

I'm going to try to find it so this is just a "I'm in on this discussion" post for now, but there have been a few areas, most notably some polynesian islands, who sustained 0 inflationary policy for centuries with no real ill effect. There were some really obvious reasons why this was good for them (resource scarcity was a big factor, along with a more communist-type "policy" setting), at the expense of extremely slow and nearly-zero growth rate.

I'll see if I can hunt down the paper, it was interesting to see an actual case study that said something other than "some inflation is critical to a society!" though it would be prohibitively difficult to apply that to a mega-country like us, especially with our current fiscal policy.

[Silvie]

Much of the discussion now is about how the typical targeted inflation rate of 2% is probably too low because when you have a big financial shock like the 2009 financial crisis you get very uncomfortably close to deflation and it is very hard to get out of.

A target rate of, say, 4% or 5% might be better for avoiding something like the ongoing malaise.

Well let's see what the European Central Bank has to say about this on Thursday.

People still talk about how, "in the good 'ol days before WWII gasoline cost $0.25/gallon", even though in real dollars its almost exactly the same price today.  "How expensive everything is nowadays" is a surefire conversation topic, even though the majority of everyday items costs the same or less today than it did 50 years ago.

Yes, my grandpa did this. He died a few years ago at the wonderful age of 101, and he was like: when I was your age, I earned 5 cents per week. Lol :D

[Hugerat]

I've often wondered why people say that interest rates can't go below 0%.  In theory, couldn't the Fed decide to set interest rates at -0.25%? 

Ah interesting. It goes to how the Fed actually operates. The Fed doesn't acutally set rates by fiat, but sets a target rate and then goes and buys and sells securities on the open market. Rates are actually market-driven and they can't go below 0% because people will just hold cash.

The idea has been floated for the Fed to charge banks a fee on the excess reserves they hold at the Fed. I suppose if that fee were high enough it could induce banks to lend at negative interest rates, but my guess is they would just reduce their reserves at the Fed and shrink their balance sheets rather than make loans at a loss.

[Hugerat]

Yes, my grandpa did this. He died a few years ago at the wonderful age of 101, and he was like: when I was your age, I earned 5 cents per week. Lol :D

Haha, yep, that's a perfect example of how most people think about inflation. They only see the numbers getting bigger and think it must be awful. But even many supposedly astute observers get it all wrong. I think it was Brit Hume on Fox News who was trying to make a point about how people earning minimum wage today have it really good. He told a story about earning $2.60 or something at a fast food joint as a teenager. Of course, adjusted for inflation, that $2.60 was way higher than even an adult working at a fast food restaurant would make today.

[Silvie]

Yes, my grandpa did this. He died a few years ago at the wonderful age of 101, and he was like: when I was your age, I earned 5 cents per week. Lol :D

Haha, yep, that's a perfect example of how most people think about inflation. They only see the numbers getting bigger and think it must be awful. But even many supposedly astute observers get it all wrong. I think it was Brit Hume on Fox News who was trying to make a point about how people earning minimum wage today have it really good. He told a story about earning $2.60 or something at a fast food joint as a teenager. Of course, adjusted for inflation, that $2.60 was way higher than even an adult working at a fast food restaurant would make today.

And in addition to inflation, don't forget lifestyle inflation. My grandpa didn't have a lot of fancypantsy stuff. My grandparents rented a modest home and they had 1 car, a bike each, and not a lot of savings (though enough to live a simple, pleasant life). After my grandpa's funeral, which was paid for by his own money, my mom received about 100 euros, because that's all that was left (they had to divide it between 9 kids).

[PeachFuzzInVA]

It's amazing that on a website dedicated to fiscal responsibility people would advocate for fiscally irresponsible policies. Inflation is good for borrowers (people who are in debt - like our federal government), it's bad for savers and bad for consumers.

Consumers want falling prices, they are GOOD for consumers. The notion that falling prices provide a disincentive to the consumer is a logical fallacy which presumes that they have something to gain by forever stocking up on dollars (paper, which has no utility other than serving as a medium for exchange). We're all savers on this website, correct? Why are we saving our money? We're saving it because we plan to SPEND IT later, not because it has some sort of artistic value like the Mona Lisa. If you're having trouble wrapping your mind around this concept because you've been taught so differently by those who have something to gain by inflationary policies (ie., our government and academia), ask yourself one question. Which consumer has more purchasing power with their dollars: the one in a deflationary environment where prices of goods are falling, or the one in an inflationary environment where the purchasing power of those dollars is being eroded as prices are rising?

Along the same lines, while inflation is good for borrowers, deflation is bad for borrowers. They tell us that deflation means that borrowers would have to pay back loans in dollars that are more valuable than the ones they borrowed (duh!). Deflation provides a disincentive to go into debt (remember the phrase, "hair on fire?") and an incentive to use current savings for investment (remember: investment = risk) purposes instead of borrowed funds ("borrowed" = bigger risk, but we ALL know that already).

Take a look a few industries with either falling prices (deflation) or rising prices (inflation) and ask yourself which seems to be working out better for the consumer.

Computers and electronics in general are a case study in how falling prices impact all of us. Remember 25 years ago when a pc would run $2000 and all you got was a lousy 40 mb hard drive and a bulky 14" crt monitor. Hardly anyone even had one in their home. Today, for less than $500 you can buy a fancy portable laptop with a 500 gb hard drive and a big, bright, high definition touch screen. It's now more unusual to NOT have a pc than it is to have multiple pc's at home. How could this possibly happen if deflation is so terrible? Could it be because companies like Microsoft and Intel have come along and done things more efficiently than their predecessors? Companies like Apple and Google are now worth nearly $1 trillion, while Bill Gates doesn't seem to be hurting for money either, so it doesn't really jive that deflation hurts businesses either, does it?

On the other hand, look at industries where prices are rising like the healthcare industry or higher education. The higher ups seem to be doing quite well, just like they are in the industries where we see falling prices rather than rising prices (hmm....could it be that they're ALWAYS going to find a way to make mega-profits no matter the economic environment?), but the consumers are suffering terribly. No longer can we afford healthcare, while many economists are saying that the student debt (there's that ugly "D" word again!) bubble is going to be the next big bubble to burst and could lead to a "lost generation" as is evidence by the record number of boomerang children coming back home to live with mom and dad because they can't support themselves even after spending $40,000 for a college education that could be had 2-3 decades ago for less than $10,000. But I thought inflation was supposed to be a good thing? Isn't it?

To summarize, in the words of economist Murray Rothbard:

...rather than a problem to be dreaded and combatted, falling prices through increased production is a wonderful long-run tendency of untrammelled capitalism. The trend of the Industrial Revolution in the West was falling prices, which spread an increased standard of living to every person; falling costs, which maintained general profitability of business; and stable monetary wage rates—which reflected steadily increasing real wages in terms of purchasing power. This is a process to be hailed and welcomed rather than to be stamped out.

[warfreak2]

Which consumer has more purchasing power with their dollars: the one in a deflationary environment where prices of goods are falling, or the one in an inflationary environment where the purchasing power of those dollars is being eroded as prices are rising?

Counter-intuitively, in a deflationary environment, consumers actually have less spending power in the long run; deflation is bad for business, and spending power relies on businesses offering to sell you things. Savers should appreciate a small rate of inflation; without it, the businesses they invest in wouldn't do so well and the savers would get low returns.

Long-term deflation means if you spend money later you get more for it; it also means if you invest money you will probably get very low returns. The "savers" on this forum are actually (mostly) putting their savings into investment accounts in order to try to live off of the investment returns; so, it's easy to see why most of us would be quite happy about a small, manageable, but non-zero level of inflation. The "savers" who benefit from deflation are the ones shoving their cash under their mattresses.

Just for example, here's Japan's inflation rate - since 1985, inflation has been very low, with a few years-long periods of deflation. With such long-term deflation/low inflation, it's better (and safer) to put your money under the (proverbial) mattress than to spend or invest it, and the result is visible in investment returns: here's a Tokyo stock market index since 1985.

[PeachFuzzInVA]

Which consumer has more purchasing power with their dollars: the one in a deflationary environment where prices of goods are falling, or the one in an inflationary environment where the purchasing power of those dollars is being eroded as prices are rising?

Counter-intuitively, in a deflationary environment, consumers actually have less spending power in the long run; deflation is bad for business, and spending power relies on businesses offering to sell you things. Savers should appreciate a small rate of inflation; without it, the businesses they invest in wouldn't do so well and the savers would get low returns.

Long-term deflation means if you spend money later you get more for it; it also means if you invest money you will probably get very low returns. The "savers" on this forum are actually (mostly) putting their savings into investment accounts in order to try to live off of the investment returns; so, it's easy to see why most of us would be quite happy about a small, manageable, but non-zero level of inflation. The "savers" who benefit from deflation are the ones shoving their cash under their mattresses.

Just for example, here's Japan's inflation rate - since 1985, inflation has been very low, with a few years-long periods of deflation. With such long-term deflation/low inflation, it's better (and safer) to put your money under the (proverbial) mattress than to spend or invest it, and the result is visible in investment returns: here's a Tokyo stock market index since 1985.

By your rational, we should no longer have access to computers, televisions, or household appliances because the producers should have stopped producing them a long time ago due to price deflation and consumers should have never bought them because prices were going to be lower in the future. None of that has happened. All of those industries seem to have survived pretty well in an environment where prices have fallen.

[nereo]

I agree with warfreak2, and add the following:
Sure, falling prices by themselves are great for customers.  However most customers are also workers, and those that are not are largely investors (in companies).  When prices fall because of deflation the companies make less money per unit sale, which directly means they are less profitable, which means they have less money to pay their employees.

This is different from the example that you gave on computers, which is really about increased efficiencies.  Computer prices (and power) aren't less today than 20 years ago because of deflation, they are less because companies have found hundreds of ways of making every component cheaper to produce, all while technological advances have made components faster and smaller. Unlike deflation, falling prices due to rising efficiencies is very good for customers and to businesses.  In fact, reading your quote from Murray Rothbard, it appears that is what he was talking about, not about deflation.

And finally, i just gotta say neither Google nor Apple have come close to the $1T mark.  I think at it's absolute peak Apple was still ~$400 billion short and google over $500B.  Just sayin'.

[warfreak2]

By your rational,

No.

That's a ridiculous false dichotomy: "those businesses survived therefore the economy is fine". Fire and brimstone opening up the pits of Hell is not the only way an economy can perform badly.

As I pointed out, returns on the Japanese stock market over the past 20 years have been pretty close to nothing; the price in 2012 was lower than in 1985, and 1985 wasn't even a boom year. The market still hasn't recovered anywhere near to its peak 24 years ago - the stock index is currently half of what it was in 1990.

[Silvie]

Now I remember why I failed economics in school... complicated stuff.

In Holland, salaries are usually (partly) adjusted for inflation. Every year most people get a 1% or 2% raise. Does that happen in the US too?

[Thegoblinchief]

It's amazing that on a website dedicated to fiscal responsibility people would advocate for fiscally irresponsible policies. Inflation is good for borrowers (people who are in debt - like our federal government), it's bad for savers and bad for consumers.

Consumers want falling prices, they are GOOD for consumers.

Policies that are good for consumers, on balance, are good for us capitalists too. All of us (real estate investors excepted) depend on profitable corporations to reach FI.

[Khan]

Inflation is bad for -mattress savers-.

For investors, it's mostly noise.

[nereo]

Now I remember why I failed economics in school... complicated stuff.

In Holland, salaries are usually (partly) adjusted for inflation. Every year most people get a 1% or 2% raise. Does that happen in the US too?

From my observations, in the US most jobs seem to have an annual raise built in.  Government employees often have an inflation and/or COLA increase in their salaries.  Unfortunately for them, these increases are sometimes 'frozen', like during the recession and recovery in 2008-2012.

[FrugalSpendthrift]

Take a look a few industries with either falling prices (deflation) or rising prices (inflation) and ask yourself which seems to be working out better for the consumer.

Computers and electronics in general are a case study in how falling prices impact all of us. Remember 25 years ago when a pc would run $2000 and all you got was a lousy 40 mb hard drive and a bulky 14" crt monitor. Hardly anyone even had one in their home. Today, for less than $500 you can buy a fancy portable laptop with a 500 gb hard drive and a big, bright, high definition touch screen. It's now more unusual to NOT have a pc than it is to have multiple pc's at home. How could this possibly happen if deflation is so terrible? Could it be because companies like Microsoft and Intel have come along and done things more efficiently than their predecessors? Companies like Apple and Google are now worth nearly $1 trillion, while Bill Gates doesn't seem to be hurting for money either, so it doesn't really jive that deflation hurts businesses either, does it?

On the other hand, look at industries where prices are rising like the healthcare industry or higher education. The higher ups seem to be doing quite well, just like they are in the industries where we see falling prices rather than rising prices (hmm....could it be that they're ALWAYS going to find a way to make mega-profits no matter the economic environment?), but the consumers are suffering terribly. No longer can we afford healthcare, while many economists are saying that the student debt (there's that ugly "D" word again!) bubble is going to be the next big bubble to burst and could lead to a "lost generation" as is evidence by the record number of boomerang children coming back home to live with mom and dad because they can't support themselves even after spending $40,000 for a college education that could be had 2-3 decades ago for less than $10,000. But I thought inflation was supposed to be a good thing? Isn't it?

Computer prices came down because of technological advancements, not because of deflation.  Sure the prices became deflated, but that is very different from an overall economic deflation.  Deflation may seem like it is good for consumers in the short term, but long term it wouldn't support all of the business that you are trying to consume from, so it would eventually become bad for consumers.  Slow steady inflation is good for the overall economy.

And higher education costs aren't rising solely because of inflation, there are many other factors pushing that up, including demand and subsidies.  Certainly not a sustainable trend, but it isn't solely to blame on inflation.

[warfreak2]

Apple and Google are now worth nearly $1 trillion, while Bill Gates doesn't seem to be hurting for money either, so it doesn't really jive that deflation hurts businesses either, does it?

Uh, hold on... you know that Apple, Google and Microsoft are American companies, right? Inflation in the USA has averaged 3% per year since 1985, and the USA has only experienced one short period of deflation (in 2009) in the last 50 years.