How high inflation will rise was the topic that economists were grappling with in the spring of 2022. After two years, the topic of discussion had changed to how soon it will fall. By 2026, a third concern has begun to surface more frequently in institutional forecasts and research papers: what happens if it drops too much?
The baseline scenario that most prominent forecasters have been using is disinflation, which is the slowing of inflation rather than its elimination. A gradual return toward central bank targets has been predicted by the IMF, the OECD, and economic modeling firms like Oxford Economics, with price increases slowing rather than reversing. It is not a semantic dispute to distinguish between deflation and disinflation. It’s the difference between an economy cooling off properly and one going into a vicious cycle where declining prices stifle investment, spending, and their own downward momentum.
Japan was in that second situation for more than twenty years. In reality, the “Lost Decade” lasted far longer than ten years, during which time prices in Japan declined so steadily that buyers learnt to put off purchases. Why buy something today if it will be less expensive next year? Once the expectation of declining costs becomes ingrained in behavior, this logic, operating at scale throughout an economy, depresses demand in ways that are quite hard to reverse. Compared to those attempting to combat inflation, central banks attempting to combat deflation confront a distinct and somewhat more difficult challenge. An overheating economy can be slowed by raising interest rates. Massive asset purchases, negative interest rates, and ongoing fiscal stimulus are more difficult to implement and less consistently successful.
Forecasters are wary of how easily the present disinflation cycle will end due to certain aspects of it. Due in part to rising supply and in part to a decline in global demand, energy prices have been declining in a number of areas. Chinese manufactured goods are entering Western markets at prices that are continuously driving down goods inflation because they are produced on a large scale by an economy with substantial overcapacity. Price drops in a number of product categories that would have been noteworthy a few years ago are now hardly noted since they come after such big gains.
Oxford Economics’ Global Economic Model, which monitors these factors in over 80 nations and is updated often, is unable to forecast a quick deflationary shock, which would manifest in a single month’s worth of data and necessitate an immediate central bank response. It simulates the interplay between declining demand, loosening supply restrictions, and changes in the labor market, resulting in a scenario where inflation keeps down but the rate and end point are still really unpredictable. The question that makes central bankers wary of lowering rates too soon is whether that endpoint is 2 percent, the target, or something lower.
Both the European Central Bank and the Federal Reserve are actively managing such uncertainty. If you lower rates too slowly, you run the risk of maintaining restrictive monetary policy long enough to cause a slowing economy to deteriorate. If you cut too soon, you run the risk of letting inflation pick up speed again before it has stabilized. Even though neither institution would openly characterize it that way, the balance they are attempting to achieve is precisely the balance at issue in the debate over deflationary risk.
