Central banks aim for price stability, and today, prices are largely stable across much of the developed world. Yet central bankers declare themselves unsatisfied. Some policymakers, most notably at the European Central Bank, are even preparing further stimulus measuresaimed at convincing financial markets of their resolve to fight deflation. But such policies overestimate the risk of falling prices.
For starters, prices are not falling now; they are just increasing more slowly than central bankers would like. In the eurozone, for example, core inflation (which excludes volatile energy and food prices) is running at about 1% per year, and markets expect it to remain at this level, on average, for the next decade.
The ECB regards such low inflation as totally unacceptable. It defines “price stability” not as stable – that is, unchanging – prices, but as year-on-year eurozone inflation of “below, but close to, 2% over the medium term.” Similarly, the United States Federal Reserve and the Bank of Japan have inflation targets of 2%.
Central banks are afraid of stable prices for two reasons.
The first is that the real value of debt automatically increases when prices fall. But fears of debt deflation seem overblown: because nominal interest rates are themselves close to zero, the real burden of debt would not increase even if prices remained stable. Moreover, the manageability of debt service depends mainly on whether incomes increase faster than the outstanding debt, not on whether the inflation rate exceeds the interest rate.
This is especially important for highly indebted governments (and households). But on that score, the picture is currently even more positive: nominal GDP growth in the eurozone remains around 3%, well above the interest rates on almost all member governments’ longer-term debt (the average refinancing cost across the eurozone is now close to zero).
As a result, eurozone governments are in a very comfortable position. Provided they run a primary budget balance of revenue and non-interest expenditure, their debt burden will slowly decline, relative to GDP. Households are also favorably placed: their incomes are growing by about 3%,