Deflation Marches On

In November, prices fell for a second consecutive month and annual inflation fell for a third consecutive month. The Consumer Price Index declined from 3.5% in August to 3.4% in September, 2.6% in October, and 2.0% in November.

A few more months of decline could turn this annual rate negative. While steadily falling prices would be a boon to individual consumers, they pose a serious threat to the economy as a whole. If many consumers delay purchases in anticipation of future price reductions, firms will reduce output in response to fewer purchases. The correspondingly lower level of employment would further depress consumer spending, forcing further price reductions.

The Bank of Canada must be vigilant to prevent such a deflationary spiral. The expansionary monetary policy needed to ward off deflation is also needed to stimulate economic activity. The US Federal Reserve’s recent announcement of a 0% target interest rate underscores that the Bank of Canada has significant room to cut from its current target of 1.5%.

The Financial Post has recently printed editorials arguing that stimulative policies will create “massive inflation.” Yesterday, the C. D. Howe Institute issued a communiqué entitled “Defending the Bank of Canada’s Inflation-Control Mandate.” Some of these commentators may point to today’s core inflation rate of 2.4% as grounds for restraining stimulus.

But it is important to examine the data more closely. The seasonally-adjusted core index rose only 0.5% from October to November after having been completely flat from September to October. Much of the apparent increase in the annual core inflation rate reflects the fact that the core index was flat or falling during the same months of 2007, which provide the basis of comparison.

The risk of deflation and the need for economic stimulus far outweigh any lingering possibility of inflation.

UPDATE (Dec. 20): The online Globe and Mail quotes Ms. Weir on deflation in “Gas prices drive down inflation.” Notably, the edited print version of this story, “Inflation increase surprises economists,” focuses almost exclusively on core inflation. The fact that overall inflation decreased significantly is not mentioned until the final paragraph.


  • A few years ago the Economist had a series of articles talking about the baffling prospect of global deflation. Their main concern was that you can’t really reduce the interest rate below 0%, which means that you’re pretty much out of monetary policy tools when deflation sets in. It’s nice to hear from people who understand monetary policy and aren’t working full-time to cover John Crow’s ass twenty years after he started the zero-inflation experiment.

  • One small point Erin: in the CD Howe paper underlying the communique, David Laidler and Robin Banerjee were arguing against focusing on a narrower price index like core inflation, preferring a wider index, like CPI.

  • Excellent point, Nick. I readily acknowledge that I was referring to the communiqué and not the paper. Here are some thoughts on the paper:

    While I welcome the argument for officially recognizing that the Bank of Canada has functions other than inflation control, I would not endorse the paper’s main thesis that more disciplined inflation control is needed to preempt financial crises.

    American CPI inflation averaged 2.6% over the past decade and never averaged more than 3.4% in any single year. Would inflation averaging 2.0% really have prevented the US housing bubble?

    The authors do acknowledge that a low inflation rate across the entire economy does not stop bubbles in particular sectors. But since monetary policy cannot target particular sectors, they conclude that it should focus on controlling inflation. Indeed, the Bank of Canada’s orthodoxy has always been based on defining monetary policy as being unable to do anything other than inflation control.

    Even if American inflation of 2.0% instead of 2.6% would somehow have made all the difference, I do not accept the implicit assumption that central banks can manage inflation with such precision. To the extent that higher interest rates reduce US inflation, they do so mainly by reducing business investment and hence the overall level of economic activity. Business investment, the most mercurial component of aggregate demand, is hardly subject to precise calibration.

    The authors passingly accept the need for “regulatory and supervisory measures” to address bubbles in particular sectors. However, their main purpose seems to be reinforcing the conventional wisdom on monetary policy at a time when many people are rightly questioning it.

  • I’m still undecided, but sort of leaning a bit the same way. I am not fully persuaded that tighter control of inflation, when it goes above target, would make a big difference. (And yes, even if they could control it that finely). I will have to post on this soon, when I get my thoughts a bit clearer. 15 years ago I argued for targeting *only* asset prices (the TSE300). Then I decided that was a daft idea. Now I’m leaning back that way a bit.

  • In today’s Globe and Mail Laidler seemed to be arguing for a ‘damn the torpedos’ full-out quantitative easing, despite the implications for inflation and despite the Bank’s lack of a mandate to do this. Mind you, I am all in favour. Interestingly, no one seems to be talking about how to finance the stimulus package, which to me is almost as important as the package itself. Do we print money by selling govt certificates to the Bank (or doing so in some more circuitous route)? Or do we finance through a global bond issue as we have in the past? Alternatively, prehaps there is some way to try and finance only on shore and why would we? All of these have different implications for economic stimulus and inflation and I would like to see some discussion of the options.

  • Well, Laidler unambiguously calls for financing the fiscal stimulus by selling government bonds to the Bank of Canada (in other words, turn on the printing press).

  • The wrong direction is to continue ‘inflating’ unreasonable, illogical, unsustainable human desires to have more for less. That road is reaping what we have today and it will continue to erode and destroy what we could have for the common good of all. Good economy or proper management of resources/assets doesn’t depend on theory and jargon but on righteous, equitable and just relationships between Almighty God, people and the earth that is demonstrated by actions of caring, saving, sharing, giving and serving to enhance the quality of life for all. If we ignore God and focus on self, then it is inevitable that our economy and ecology and social responsiveness will get out of wack and we will reap bad consequences and pain for many. It may seem simplistic but it is the truth – we need to get back to God through Jesus Christ and his Kingdom – it is the only way.

  • We are right about now, this moment, gaining some real traction in the deflationary spiral. Toyota announced today that it is asking its workers for pay cuts. The big three is about to set out on a similar pathway with its apparent government ordered negotiation of the big three pattern bargain. We are not only seeing wage stagnation but now we are seeing some fairly large motivational pushes towards the abyss.

    It is precisely the economic motivations of market forces that kick the deflationary spiral into high gear. The major producers start cutting to scoop the up a bigger piece of the ever deflating smaller pie.

    I guess the question remains, can government stimulus help stem the tide?

    Well, lets see, who is ordering the workers in the auto sector to reduce their wage and benefits package. Cureently it is seemingly the same government who states it wants to stimulate the economy.

    When you are stuck in the ditch, how does having the tow truck push you further into the ditch help get you out.

    So I guess now that Toyota has asked for cuts, GM and the big three will have to ask for even bigger cuts.

    Okay so when do the auto workers start putting up a fight is what I want to know. Somebody has got to put some rationality into this. Hopefully the Obama regime sees the irrationality of this and changes course.

    It could be the defining moment for the economic leadership of this new regime.

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