Perhaps I am economically naive, but why does there need to be any inflation? Why isn't 0 a target?
Inflation encourages investment - you need to invest in securities with a rate of return at least as good as inflation in order to not lose money. Incentives are aligned to make you do the thing that keeps the cycle going.
Deflation encourages hoarding - you would do better to keep the money under your mattress and wait for prices to fall before circulating it. Incentives are aligned to make you do the thing that destroys the economy.
Inflation in principle isn't horrible, but inflating prices while wages stagnate leaves everyone objectively worse off than they were before. This is already happening to an extent and causes a baseline level of unhappiness; if it were to get out of control things would be very ugly.
The task of a central bank is to use some very broad levers (interest rates, creating currency, etc) to try to keep the rate of inflation low but positive.
Economists discount deflation as being dangerous with just one sentence (it encourages hoarding). Are there any examples of deflation actually being harmful in an economy? There are plenty of examples of inflation being dangerous [0]. Technology is an example where deflation does not encourage hoarding.
If I bought a computer for $600 in 1980, it's not going to be traded for $600 today. But if I got a $600 check in 1980, I could cash it today for $600. Inflation is what makes this a reasonable thing to do. If money deflated, I wouldn't cash my check, I'd want to hold it for as long as possible. Deflation basically means you collect interest on any cash you have.
I don't see how that's different from choosing not to spend $600 for a computer today knowing that it'll be only cost $500 a year from now. You buy it today because it has a higher value to you now rather than a year from now (we still prefer things sooner as opposed to later, despite deflation). You would also may choose to cash in the $600 knowing well that it will be worth more if you wait because you want to spend it on something now.
Even with deflation, people would still spend money as we prefer to consume now rather than later. If cash had a positive return, I'd imagine riskier assets would have an even greater return so you wouldn't necessarily be all tied in cash. I know cash has a negative return (due to inflation) but I still hold it.
What we're talking about is investors buying things (like capital equipment) for the purpose of making money. But even for an individual - would you go $200k into debt for a house that's going to be worth $50k in 10 years? Of course not! A rational actor would even shy away from leases - you want to jump to something cheaper (or better for the same price) as frequently as possible, to minimize the amount of time that you're paying above market value for housing. Just like how you want to move between tech jobs relatively frequently to minimize the amount of time you're being paid below market value.
People buy smartphones because they want smartphones, not to make money on them. Rational capitalists, on the other hand, use their assets in a way that maximizes gain and minimizes risk.
In an inflationary economy, the best investments are profitable businesses, or derivatives/aggregates thereof. Your capital is put to use buying means of production that makes more money than it costs and employs people along the way. Every year, the prices of the products you sell rise higher, but you've already paid for the factory! And you're incentivized to fund that factory now, because factories are only going to get more expensive.
In a deflationary economy, cash is a low-risk/high-reward investment. Business, meanwhile, is hard - high-risk, aggregate low reward. Yes, consumers have more buying power, but production capacity is created and scaled by going into debt to buy capital equipment. In a deflationary economy, the real value of debt is increasing while prices are falling. So every day, the output of your assembly line is worth less, but what you owe on the line itself hasn't changed. You just have to hope that you can pay off the factory and make some profit faster than the price of the widget it makes approaches zero.
Why isn't this the case with technology? Because with technology, the rate of descent of the price people will pay for, say, smartphones still leaves room for a profit margin compared to the rate at which production is getting cheaper, and last year's high-end production lines are still useful for making what's now a third-world phone.
When you eventually get to a point of losing money on your factory, you lay off your employees, who now have less money to buy things from other factories, and if the economy gets on the wrong side of that snowball you're looking at hell. The more this happens, the more likely investors are to stop investing in businesses and park their wealth in cash. The same checking account balance will always be able to buy a bigger factory tomorrow. You effectively stop the pump of economic activity, causing recession.
In the crudest terms, the central bank printing currency like crazy can make sitting on cash an even worse option than investing in business again, so you opt for the latter.
tl;dr deflation makes it more rational to own money and less rational to own things that try to make money by employing people.
Lets say a store has $50,000 worth of inventory bought on revolving credit. In normal times, $50k worth of inventory might sell for $100k. The $50 worth of gross margin goes to pay, labor costs, rent, and the owners take. Lets say due to deflation that 50k is now only going to sell for $90k, the business is short $10k. What's the owner going to do?
Go out out business that's what.
So the problem with deflation is it tends to rape the books of perfectly well run businesses. And then you get cascading failure. The mill has a cash flow problem, goes bankrupt, and then half the business in town close.
A most subtle problem is a lot of businesses really run on credit backed by pledged collateral. The chain of collateral forms what called a credit chain. When you have deflation and a demand slump the assessed value of the collateral becomes suspect. Credit chains shorten and collapse. And businesses can't get liquidity. And then fail.
It goes on and on.
According to the Federal Reserve Bank of Minneapolis, no: https://www.minneapolisfed.org/publications/the-region/defla...
In fact, one of the theorists there suggested a rate of -3% (or 3% deflation) might be optimal.
I am not skilled in econ, but isn't this because the utility of new technology increases faster than inflation? In other words, utility(technology1, t1)/cost(technology1, t1) < utility(technology2, t2)/cost(technology2, t2).
Ignoring any affects of supply and demand,
If I buy a tractor 1.0 today for X dollars to produce Y units of utility (i.e. Y/X), but tomorrow tractor 2.0 costs 2X dollars (with inflation) to produce 4Y units of utility (i.e. 2Y/X), then my tractor 1.0 should be worth 1/2 dollars tomorrow (assuming that it still has Y units of utility). And, I may buy a tractor 2.0.
But, if on the next day, tractor 3.0 comes out and still has 4Y units of utility (technology stagnation) but costs X dollars (deflation occurs and production costs have gone down), then my tractor 2.0 should be worth 4X dollars. I'm not going to buy tractor 3.0.
This is even more true for some things than others... few people are going to say "Hey, deflation is on, let me wait until next week to eat" when they're hungry today.
I'm not saying deflation is good or anything, but an awful lot of economic theory is rooted in some pretty shaky foundations.
Basically, it's because people want to see their wages go up, and a central bank loses the power to set short term interest rates when inflation is 0%, as we've witnessed in the US over the past 6 years.
When banks make a bad loan and are forced to write of the loan each dollar of loss results in 11 less dollars of loans that can be made. When this happens to a lot of banks at the same time you get a general decrease in the money supply and general deflation (like the Great Depression).
A positive rate of inflation allows banks to resolve some bad loans simply by holding the loan until inflation increases the asset value above the loan amount rather than a write-off. Positive inflation, in other words, is a lubricant for the banking system to make it easier to resolve bad loans which makes issuing loans simpler.
With zero percent inflation banks would demand higher standards for underwriting such as stronger credit and larger down payments. that would generally mean loans would be directed mostly towards older, larger and more established industries and less to newer and smaller industries. Less loans for young people and more for older people.
As a side note what makes the Federal Reserve special is that it is allowed to make loans with infinite leverage on capital. That means instead of a 1 to 12 ration of a typical bank it could be 1 to 100 or 1 to 1000. To keep this special position any profits are foreited to the U.S. Government and implicitly any losses are also eaten by the U.S. Government as well. Which is why which assets the Feseral Reserve purchases is a sensitive topic.
Very theoretically it sets a "you must be this tall to play" floor on stock financed capital projects. So if inflation is 4% and you think new railroad locomotives will pay off at 5% average, then you do it, or if new locos only pay off at 3% then you don't because you'd get a sub-inflation rate of return on stocks or bonds.
Another argument is its essentially a long term debt jubilee, given the extremely optimistic assumption that wages rise with inflation (LOL, not so much since the 80s or so). So at both personal and corporate level, debts as a problem kind of go away with time. A decade of 70s style wage inflation would certainly help with the student loan crisis and the real estate price crisis.
But the moment inflation dips below zero it really starts discouraging spending.
So I suspect it's about having a margin for error. Target zero and it will spend a lot of time negative, target mildly positive and it will spend most of its time mildly positive.
While this view is common, it is incorrect.
This is obviously evident when you consider the price of computers and other tech products over the decades.
I never said deflation cannot defer people's demand. The comment I originally responded to indicated that a deflation rate of 1% would, in general, discourage spending. I would wager, that almost no one defer buying an iPhone if they knew for a fact that it would be 1% cheaper a year later. Just as I don't think that knowledge that the price would be 1% higher a year later would cause someone to buy an iPhone they were not already planning on buying.
What I'm getting at is falling prices, in and of themselves, are not a huge problem. If you want to say that a deflation rate of 20% would cause huge problems, ok, maybe that's true for some products. Conversely an inflation rate of 20% would cause huge problems in some realms. Inflation is not generally good and deflation generally bad--that is the myth I'm addressing.
This is one thing I've never understood about this whole "inflation incentivizes people into spending now rather than later". If we're simply pushing the demand into the future, aren't there already people from the past whose "future time to spend" is the current moment?
<opinion type="rant"> From my perspective, all that I see inflation doing is artificially forcing people to put more money into the stock market and investing than they should be.