Over the last two years, the biggest economic story has been very high levels of inflation in the United States and abroad. It may not have been as bad as inflation in the 1980’s, and it certainly was not as bad as some historical examples of hyperinflation, but people are feeling the effects of rising prices across the country after decades of stable prices.
A Pew Research poll from earlier this year found that 62% of respondents believed that inflation was a “very big problem” in the country today. This is despite inflation falling to 3.3% according to the Bureau of Labor Statistics, which (while still being slightly elevated) is not extremely concerning.
Some of this can be attributed to the rise in political partisanship over recent years, but there are some valid underlying economic concerns leading to this economic discomfort as well.
Many people may think the best scenario would be for prices to return to pre-pandemic levels, undoing the harm of the past couple of years. However, ask any economist and they will warn you that deflation of any kind might be even more harmful than the last few years of inflation.
This is because when prices are falling, there is a strong disincentive to spend money in the present. When prices are falling, the cash you currently have is becoming relatively more valuable every day. When deflation is expected, spending money is losing money.
Compare that to inflation, where the incentive is to spend as much money as possible since cash becomes less valuable over time. During inflationary periods there is an incentive to participate in the economy, while during deflationary periods there is an incentive to stay home.
These relative changes in economic activity don’t really happen on the day-to-day level. Everyone still needs to go out and get groceries after all. But inflation and deflation can change the way big economic decisions are made.
Another advantage inflation has over deflation is that we have macroeconomic tools to help balance the impacts of inflation. The Federal Reserve can increase interest rates to make money more expensive, reacting to the fact that during inflation money is more valuable than goods.
If we were experiencing deflation, then the Federal Reserve would have much fewer options. There is the option of negative interest rates, but those are extremely controversial. In other contexts, countries that have employed negative interest rates have been successful in keeping their economies moving while avoiding the worst case scenario.
The risk of negative interest rates is that they make it costly for people to hold money in a bank. If everyone were to withdraw all their money, it could erode the stability of our financial system.
Inflation has been an extremely difficult problem for many people, but prices are likely not going to fall to pre-pandemic levels. Trying to spark deflation would likely lead to even more problems than elevated prices.
Instead, we should be looking for wages to rise to meet the higher prices. This may take some time since wages are notoriously sticky, but at the end of the day it is far better than dealing with any sort of deflation.