All else equal, we probably need to see not just stable prices of commodities and other tradable goods if we’re to meet the target over a reasonable horizon, but some further acceleration in domestic costs as well. While that’s what the central forecast in the February Inflation Report entails, the MPC will obviously have to be watchful, in the meantime, for signs that “good” deflation is turning into something worse. But we should not over-state the risks. The costs of deflation: income and interest rates matter too Something one hears quite often is that deflation is a problem “because it encourages people to postpone consumption”. Deflation – or more precisely the expectation that prices will fall – therefore weakens demand, it is said, and this can lead to a vicious circle in which prices are then depressed further. As far as it goes this has some truth to it. But it’s at best a partial description of the problem, at worst a bit misleading. It leaves out two important considerations. One is nominal income. Suppose you’re told that prices will fall over the next year but that the value of your income will remain unchanged. All else equal, the prospect of falling prices will give you an incentive to save more of your income (i.e. to postpone a bit of consumption). At the same time, the real value of that income will prospectively have risen.
“Core” inflation is still running at over 1% and, barring another steep decline in food and energy prices over the next year, headline inflation is likely to rise quite steeply in early 2016. I’m also struck by the rarity of persistent deflation in the past 15, particularly amongst countries with an independent monetary policy. As we’ve seen, long periods of falling prices were perfectly common during the Gold Standard. That’s inevitable under a commodity peg if, over any period of time, the commodity itself is in fixed supply. The same was true in other countries at the time and, infamously, during the Great Depression. It was only when Britain came off gold, in 1931, that its nominal income started to accelerate 16. And since the Second World War, and the abandonment of commodity standards, positive inflation has been the norm – so much so, in fact, that the commonly cited example of the Japanese deflation is almost unique. Chart 12a Deflation episodes are rare  Chart 12b Even rarer in countries with floating exchange rates  Source: Bordo and Eichengreen, IMF and OECD  Source: Bordo and Eichengreen, IMF and OECD  Note: Sample 1960-2010; 3300 observations  Note: Sample 1960-2010; 3300 observations. 15  A very recent paper by Claudio Borio and co-authors at the BIS makes the same point (Borio et al. (2015)); see also Broadbent et al (2010). 16  For more on the contractionary effect of the Gold Standard during the Great Depression, see Eichengreen (1996).