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Inflation Isn’t Too High; It’s Too Low

After years of modest price increases, the American public commonly misconstrues inflation.  Today, consumers still cannot wrap their heads around the ideas that inflation is really low and that inflation can be too low.  Over the past year through February, the Consumer Price Index rose only 1.1 percent.  Although consumers enjoy the relatively low prices for goods, low inflation causes three problems for the whole economy.

One problem with low inflation is that it negatively affects wages.  When prices do not generally go up, workers’ wages do not generally go up as well.  Despite the low inflation levels in the United States, hourly and weekly earnings have rose pretty well over the last year.  During this time period, hourly and weekly wages have increased by 4 percent and 3 percent respectively.  However, these rising wages are not sustainable because employers will not keep raising their employees’ wages faster than the price they charge consumers.

Another problem is that a certain amount of inflation is actually good for employment.  The reason why some inflation is good is because it creates a money illusion.  When demand is slack, employers try to reduce the costs of production by cutting real wage expenses.  In times of moderate inflation, employers can cut real wage expenses easily by giving their employees raises that are lower than the rate of inflation.  However, in times of low inflation, employers have to use extreme measures to cut real wage expenses.  In this case, employers handle this problem by laying off workers.

Third problem with super-low inflation is that in can lead to deflation.  Deflation is bad because it discourages consumers from buying goods because they believe they can get goods cheaper if they wait.

Central bankers have come to the conclusion that 2 percent of inflation is good for the whole economy, but they keep missing this target.  Since the financial crisis, the Federal Reserve and the European Central Bank have reluctantly taken measures to stimulate growth and raise inflation.  They are reluctant to do so because they fear that stimulating growth could create another asset bubble and possibly cause too much inflation.  For example, the euro-area inflation slowed to its lowest level in four years.  Over the past year, consumer prices rose only by 0.5 percent.  With these potential problems with low levels of inflation, central banks need to act by raising inflation.