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Friday, March 28, 2008

Mishkin: Can Inflation Be Too Low?

by Calculated Risk on 3/28/2008 01:32:00 AM

Federal Reserve Governor Frederic S. Mishkin spoke tonight: Comfort Zones, Shmumfort Zones. Mishkin tries to answer the question of why 1% to 2% inflation it better than zero inflation:

Can Inflation Be Too Low?
While the benefits of low inflation are now widely recognized, somewhat less attention has been given to the pitfalls of maintaining inflation rates very close to zero, so I will now discuss this issue in somewhat greater detail. Specifically, if the average inflation rate is too low, then the economy faces a greater risk that a given adverse shock could distort labor markets, induce debt deflation, or cause monetary policy to become constrained by the zero lower bound on nominal interest rates. These risks imply that undershooting a zero inflation objective is potentially more costly than overshooting that objective by the same amount, and that setting the inflation objective at a rate a bit above zero provides some insurance against these risks.

Downward nominal wage rigidities. Inflation at rates close to zero might create nonnegligible costs to the economy because firms may be relatively reluctant to cut nominal wages. Sticky nominal wages can prevent labor markets from reaching the optimal equilibrium. However, empirical evidence from Switzerland and Japan indicates that in an environment of deflation or very low inflation, downward nominal wage rigidities become less prevalent.

Debt deflation. Keeping the average inflation rate close to zero increases the likelihood that the economy will experience occasional episodes of deflation. Deflation can be particularly dangerous for an advanced economy, in which debt contracts often have long maturities. As described by Irving Fisher (1933), an episode of deflation can lead to "debt deflation," that is, a substantial rise in the real indebtedness of households and firms, because the nominal values of debt obligations are largely predetermined whereas the nominal values of household income and business revenue are falling together with the general price level. Indeed, the deterioration of the balance sheets of households and firms can result in financial turmoil that contributes to further deflation and greater macroeconomic instability.

The zero lower bound. With a very low average inflation rate, monetary policy is also more likely to encounter circumstances in which short-term interest rates are constrained by the so-called zero lower bound on nominal interest rates. Specifically, investors will never choose to lend money at a negative nominal interest rate because they always have the option of simply holding cash at a zero interest rate; thus, nominal interest rates cannot fall below zero.