The Perils of Falling Inflation

Central banks are national institutions that regulate currency and monetary policy. Typically, they are on watch against excessive inflation which can erode currency values. But low inflation that transforms into deflation may be a bigger problem. “As Japan’s experience shows, deflation is both deeply damaging and hard to escape in weak economies with high debts,” warns the Economist. “Since loans are fixed in nominal terms, falling wages and prices increase the burden of paying them. And once people expect prices to keep falling, they put off buying things, weakening the economy further.” In turn, debt combined with inflation that is too low leads to a high rate of unemployment, as is evident in the southern Europe and the United States. The downward cycle of prices and jobs adds to the challenges of central bankers who have few options for encouraging spending and growth, having already reduced interest rates to close to zero – especially if another recession hits. – YaleGlobal