Wednesday, November 26, 2014

A difference in 2% for inflation - the world of difference

If we have 2% inflation, central bankers around the world believe the world will be a good place.  Economic growth, in their view, should be at or above trend. Inflation targets will be met and even if purchasing power is eroded each year, consumers and investors should be happy with "optimal" price increases. 

If we have 0% inflation, a 2% decline, there is the belief that economic growth will stall and we will be in a potential economic emergency. If we have 2% deflation, it seems central bankers think the world will be coming to an end. The world will be in a crisis which would require immediate action and the coordination of economic leaders. An increase above 2% would hardly cause much panic by central bankers. 

The non-linear response to declining inflation below 2% seems extraordinary. Inflation approaching zero and potentially going negative has a grip on the thought process of all policy-makers. A fear of deflation or zero inflation is justified, but are consumers and investors as sensitive to a 2% decline below target as central bankers? What is the sensitivity to money illusion? Are there a set of (non-monetary) policies that can offset the fear of living below the 2% target? 

Our thinking about inflation at 2%, 0%, and -2% levels has be better refined and clarified if we are going to survive the next few years. The fear of 2% below the inflation target has to be replaced with actions that can reduce market uncertainty and foster growth and productivity.

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