Deflation stemming from insufficient demand and growth-constraining economic policies can drain confidence and become negatively reinforcing, as Japan has shown. In such situations, aggressive macroeconomic policy stimulus designed to jar expectations and boost demand is appropriate. Europe’s downward price and wage pressures are necessary adjustments to its earlier excesses, and relying excessively on aggressive monetary policy to stimulate demand is not a lasting economic remedy. Europe is not destined to fall into a Japanese-style prolonged malaise, but it must continue to pursue reforms that lift productive capacity and confidence.
The US situation is very different. The economic expansion is gaining momentum (temporarily sidetracked by unseasonal winter storms), unemployment is falling steadily, personal income is growing faster than inflation, and household net worth is at an all-time high. Expectations of deflation are not apparent in either household or business behaviour. Concerns about lingering labour-market underperformance are warranted; angst about deflation is not.
Prices of some goods and services in the US have been falling, benefitting from technological innovation, improved product design, or heightened competition and distribution efficiencies through the internet. Examples abound: flat-screen TVs, computers, automobiles, reduced fees on financial transactions, online consumer and business purchases, etc. These lower prices and quality improvements explain the vast majority of the recent deceleration in inflation – the PCE deflator for goods continues to decline and is flat for nondurables, while it has been rising at a fairly steady pace of 2% for services.
These innovation-based price reductions improve standards of living and free up disposable income to spend on other goods and services. They boost aggregate demand and enhance economic performance. And they contribute positively to longer-run potential growth.
It is unclear why US policymakers and commentators fear disinflation that stems from innovation-based price reductions amid accelerating aggregate demand. European policymakers face tougher choices.