A 99-Cent Hamburger Isn't Deflation

Why the Big Deal?

Why is falling inflation such a big problem to the Federal Reserve? Most of us who can remember the high inflation of the 1970s and 1980s reflexively think that inflation is a bad thing.

The Federal Reserve's thinking goes like this, in the governors' own words: "Indeed, the members did not rule out the emergence of appreciably lower inflation. In this regard, some observed that a significant decline in inflation from current levels could imply an unwelcome tightening of monetary policy in real terms. In addition, further sizable disinflation that resulted in a nominal inflation rate near zero could create problems for the implementation of monetary policy through conventional means in the event of an adverse shock to the economy that called for negative real policy interest rates."

This fear of further declines in an already-low inflation rate is a likely explanation of the Federal Reserve's stronger-than-expected move last week. Current levels of inflation give the central bank room to use interest rate cuts to get the economy moving. With inflation at an annual 2.2% in September (as measured by the Core Consumer Price Index, anyway), any bank that borrows from the Federal Reserve at 1.25% is getting money for less than nothing; the future dollars it has to pay back are worth 2.2% less, but the bank is paying only 1.25% to secure them.

The real interest rate that a bank pays to borrow from the Federal Reserve at this point is actually a negative 0.95%. With those kinds of numbers, banks have a real incentive to borrow money, which increases the money supply, makes credit easier to get, and, in general, greases the wheels of the economy so that it can run faster.

But if inflation sinks further, interest rate cuts increasingly lose their power. If inflation falls to 0.5%, for example, and the fed funds rate stays at 1.25%, banks are borrowing at a real interest rate of 0.75% instead of -0.95%. They've lost 1.7 percentage points of incentive to expand their borrowing.