FREE ESSAY ON ZERO INFLATION

ZERO INFLATION

Introduction
Hyper inflation has plagued most of the world's developing countries over the past
decades. Countries in the industrialised world, too, have at times duelled with
dangerously high inflation rates in the post WWII era. With varying degrees of success,
all have employed great efforts to bring their inflation rates within acceptable limits.
Generally, a moderate rate of inflation has been the ultimate goal. More recently,
however, a few countries have pursued policies that strive to eradicate inflation
altogether through complete price stability. This has proven to be a contentious
enterprise, which clearly indicates that there is still no universally accepted solution
to the inflation problem. Indeed, there is not even an agreed consensus regarding the
source of inflation itself. The monetarist perception that the root of inflation is
solely the excessive creation of money remains. So too does the belief that inflation
originates in the labour market. And amongst a variety of others, the opinion that
inflation "serves the critical social purpose of resolving incompatible demands by
different groups" is also strong. This last, and more widely accepted, case shows that
the problem is hardly a technical one; but rather a political one. It highlights the now
unquestionable fact that politics and inflation are inextricably linked. And as with all
inherently political issues, consensus is difficult, if not impossible, to achieve.
But, political characteristics do provide flexibility. In some countries, high rates of
inflation have clearly been compatible with rapid economic growth and fast rising
standards of living. In such cases, it is quite reasonable to suggest that higher rates
of inflation are acceptable--perhaps even necessary. In this setting, it is by no means
clear that pursing a policy to stop moderate inflation is either required, or in the best
interests of the mass of the population at all. While inflation guarantees that some will
gain at the expense of others, the redistributions of income and wealth which do take
place can, on normal value grounds, be quite desirable. 
In other circumstances, it may be quite desirable to place strict controls on inflation,
or strive to keep it at 'zero' level. Policies aimed at virtual price stability have been
in use by central banks in Europe, New Zealand, and Canada over the past few years. Such
policies have been particularly focused in Canada. As noted by Pierre Fortin, "the only
objective the Bank of Canada has pursued since 1989 has been to establish and maintain
the inflation rate at 'zero level', which it sees as a CPI inflation rate that is clearly
below two percent" (italic added). To the surprise of many, it has been incredibly
successful, achieving its objective several years before schedule. 
Although separated by only a few percentage points, Canada's policy is a sharp contrast
to the moderate and balanced approach used in the U.S. "Since 1989 the Federal Reserve
has been satisfied with achieving an inflation rate of around 3 percent. In setting the
interest rate, it has continued to pay explicit attention to real economic growth and
employment, with the result that the U.S. unemployment rate is currently in the 5 to 6
percent range." Based on this statistic alone, it can be argued that the more moderate
U.S. approach has enjoyed greater success than the deflation oriented policy pursued by
the Bank of Canada: Canada continues to be burdened with a higher rate of unemployment.
Yet, it continues to believe that the unemployment costs of low inflation are 'transitory
and small' . The directors of most European Central Banks also continue to support this
dogma. Clearly, the credibility of the "classical idea that the Phillips trade off
between inflation and unemployment disappears in the long run" is still very high
throughout the world. But, in Canada, as in most of Europe, the waiting continues.
This is not to suggest that the waiting game has been silent and entirely pleasant.
Indeed, the relative lack (or lag!) of success of zero inflation policies and strict
price controls has spurred much heated debate. As a case in point, more people are
curious why Canada has exclusively focused on inflation cutting and turned a blind eye to
the more balanced, and arguably more successful, approach adopted by the U.S.. Is it
actually desirable, or wise, to aim towards virtual price stability? Are there real
long-term benefits to low, or zero, inflation? What are the real effects of low
inflation? The intensity of the ongoing debate on these issues provides evidence that
there are no straightforward answers. 
The purpose of this paper is to probe at these issues in an attempt to cast some clarity
on the debate. Appropriately, it begins with an analysis of the consequences of low
inflation on the conduct of monetary policy. As is well known, these effects are
controversial, and this paper in no way purports to end the deadlock. Bringing the
relevant issues to the fore, however, is equal to carrying a well-stocked toolbox that
contains many of the necessities for well-crafted opinions.
The Consequences of Low Inflation on Monetary Policy
In recent years, monetary policy has been promoted to the centre stage of economic policy
making the world over. This is a contrast to the first half of the 20th century when it
was relegated solely to experimentation in the shadows. During these early years, fiscal
policy was solely used; due in part to the depression of the thirties, and the remainder,
to the process of post WWII reconstruction and the Keynesian doctrine that fiscal action
was necessary to prevent deficiency in aggregate demand. By the late sixties and early
seventies however, most of the developed world was witnessing the emergence of a
combination of high inflation and low growth; i.e., stagnation, and the revered Keynesian
analysis was unable to devise plausible responses to the phenomenon. Consequently,
monetary policy emerged as an eminent instrument of economic policy, particularly in the
fight against inflation. Issues related to the conduct of monetary policy worked their
way to the forefront of policy debates during the 1980's as growth and price stability
were the intermediate and long term objectives. Gradually, a loose consensus emerged
among industrially advanced countries that the dominant objective of monetary policy
should be price stability, and from the outset of the 1990's, this belief has increased
in popularity. However, differences continue to exist among central banks with regard to
the appropriate intermediate target. While some consider monetary aggregates and,
therefore, monetary targeting as operationally meaningful, others focus exclusively on
interest rates-even though the inter-relationship between the two targets is well
recognised. Again, as with all inflation-related issues, there seems to be little
consensus.
Though it will only be noted in passing here, monetary policy has also gone through a
renaissance in developing economies. Much of the early literature on development
economics focused on real factors such as savings, investment, and technology as the main
springs of growth. Very little attention was paid to the financial system as a
contributory factor. Indeed, through the years countless opinions have highlighted that
inflation is endemic in the process of economic growth and is accordingly treated more as
a consequence of structural imbalance than as a monetary phenomenon. However, with a
growing body of overwhelming evidence, it has become clear that any process of economic
growth where monetary expansion is disregarded also leads to inflationary pressures with
resultant impacts on economic growth. Thus, price stability and monetary policy have
assumed increased importance all over the world, in developing and developed economies
alike.
Yet, the widespread use of monetary policy to control inflation does not necessarily
muffle the roars of policy debate. In fact, the extent to which price stability should be
deemed to be the over-riding objective of monetary policy has become an increasingly
heated topic of discussion. The crucial question seems to be whether the pursuit of low
inflation; (i.e., price stability) through monetary policy undermines the ability of an
economy to attain and sustain higher growth. A substantial body of research occupies the
examination of this trade-off, whose roots trace back to the Phillips curve (1958) which
demonstrated the inverse relationship between the change in wage rates and unemployment
rates. It was here that the suggestion of a trade-off between inflation and unemployment
was first laid. Although the 'Phillips' relationship has subsequently been challenged on
theoretical and empirical grounds, it continues to form an important locus of analysis
and it is prudent to look at in some detail below. 
The Phillips Curve
It is well known, and generally accepted, that the downward slope of the Phillips curve
arises basically because of the presence of money illusion and expected inflation
deviating from actual inflation. Based on this knowledge, and its subsequent critiques,
the prevailing inflation/monetary policy controversy centres on the possible short-run
and long run trade-off between inflation and unemployment. This distinction primarily
stems from the "assumption of 'error-learning' process in the determination of
inflationary expectations - workers do have an anticipation on the inflation, but because
they judge the inflation performance from the past data, the adjustment between the
expected and actual inflation is slow." This implies that in the short-run, nominal wage
rise will not fully absorb the actual inflation, and as such, there is scope for reducing
unemployment through inflation. "As people adjust their expectations of inflation, the
short-run Phillips curve shifts upward and unemployment rate returns towards its
'natural' level. As the expected inflation catches up with actual inflation, the Phillips
curve becomes vertical, denying thereby a 'trade-off' between inflation and unemployment
in the long run." Seen in this light, the short term Phillips curve provides a trade-off
between inflation and unemployment when an economy is adjusting to shocks in aggregate
demand when expected inflation is lower than actual inflation. In the long run, the
Phillips curve becomes almost vertical at the (controversial) 'natural' rate of
unemployment. Though not discussed in this paper, the plausibility of this 'natural' rate
of unemployment has been cast into doubt in recent years. 
For the moment, notwithstanding the critique of the 'natural' unemployment rate, the
Phillips curve presents the possibility of lengthening the short-run 'trade-offs'
indefinitely, since inflation surprises in each period can elongate the long-run
perpetually. But, in that case the 'trade-offs' will become sharper in each successive
period. In other words, to maintain the unemployment below the 'natural' rate, policy
authorities will have to inflate the economy at higher rates in each successive period.
This has a major policy implication even if the economy does not operate on the long-run
vertical Phillips curve. "Under the rational expectations hypothesis, as there are no
deviations between actual, and expected inflation, both in the short-run and long-run,
Phillips curves are treated as being vertical with no trade-off between inflation and
unemployment." 
Another policy related question is the shape of the short-run Phillips curve itself. In
reality, wages and prices are sticky as employment contracts are fairly long and there is
also a cost in changing the individual prices too often, or re-negotiating wages after
each price rise. It has been argued that the nature of stickiness in wages and prices
could be different in different economies, and this could also be a function of the
inflation history of the country concerned. If so, countries with high inflation rates
would find themselves steeper on short-run Phillips curve than low inflation countries,
which are more likely to be on the flatter side. For the purpose of this paper, what is
important, therefore, is that the trade-off between price stability and employment is
sharper for countries with relatively high inflation rates, and lower for those with low
inflation rates.
Price Stability as the objective of Monetary Policy
Price stability as the objective of monetary policy rests on the notion that volatility
in prices creates uncertainty in decision making. Rising prices affect savings adversely
while making speculative investments more attractive. Thus, the most important
contribution of the financial system to an economy is its ability to increase savings and
allocate resources more efficiently. A regime of rising prices dampens the atmosphere for
promotion of savings and allocation of investment. Moreover, there is a social element:
inflation adversely affects those who have no protection against inflation; i.e., the
poorer sections of the community. The critical question for policy makers is, thus, at
what level of inflation do its adverse consequences begin to set in? 
Inflation affects fiscal balance in several ways. "It adversely affects fiscal deficit
when elasticity of expenditure to inflation is higher than that of revenue. A more
significant impact of inflation arises from its effect on interest rate and the dynamic
sustainability of fiscal situation. High rates of inflation signal weak resolve to
control inflation and imply higher expected inflation in future." Obviously, this results
in upward rigidity in nominal interest and leads to high debt service burden on the
budget, thus reducing the flexibility of fiscal management. And as just noted, it is well
known that the adverse implications of inflation are more intense at high rates of
inflation. A moderate inflation rate is usually more desirable, and manageable as it
ordinarily does not imply severe costs. Indeed, moderate inflation rates are necessary if
money is to remain a useful unit of account and if the costs of decision making are to be
minimised. But, there is no consensus as to the optimum rate of moderate inflation, or
even as to what the term 'moderate' means. "International evidence suggests that the
costs of uncertainty tend to rise in a non-linear fashion with the inflation rate
exceeding a threshold. One important caveat in interpreting the threshold of inflation
rate beyond which costs exceed benefit is the provision of inflation protection measures
available in the economy, which tends to moderate the adverse implications to some
extent." In other words, countries with a moderate inflation rate, but an inadequate
indexation provision, may show a higher degree of sensitivity to inflation than those
with lower 'moderate' inflation. For example, as noted above, most of the industrialised
countries in recent years have inflation targets ranging between two to three per cent.
But, among the developing countries, some of the fast growing East-Asian economies have
not only demonstrated low inflation rates ranging between three to five per cent, but the
growth rate at these inflation rates has been fairly high at around eight per cent.
Empirical evidence on the relationship between the inflation and growth in cross-country
framework is therefore somewhat confusing. Several studies make it clear that the
negative impact of inflation on growth is more severe at unmistakably high rates of
inflation, there is no consensus about the threshold inflation rate beyond which, or
under which, the negative impacts of price stability become pronounced. The term
'moderate' or 'low' inflation is clearly relative and dependant upon a number of
circumstances. In part, this fact also obscures the analysis of policies that seek zero
inflation, or virtual price stability.
The effects of virtual price stability
Most policy makers generally worry about inflation, however moderate, because if not held
in check, a little inflation can lead to higher inflation and ultimately affect growth.
Several central banks believe that the "economic benefits of reducing inflation, say,
from 4 per cent to 2 per cent, are 'many and large' and the unemployment costs are
'transitory and small' by comparison." This perception rests on the Friedman's "classical
idea that the Phillips trade-off between inflation and unemployment disappears in the
long run, and even in the short run if the central bank's commitment to zero inflation is
made credible and has a direct downward effect on expected and actual inflation that
minimises the unemployment costs of disinflation." Yet, this appears to be more plausible
in theory than in practice. As a case in point, the Bank of Canada has argued that the
country's "inflation could not have been minimised without a short-term rise in
unemployment and government debt." Thus, they concede that there are indeed short-term
costs, although they hope that they will be outweighed by the long-term benefits.
According to this view, benefits will accrue because of Canada's resultant low-inflation
environment, which will promote both the stability and competitiveness of the Canadian
economy. This should result in a protracted increase in business investment. Yet, the
economy continues to feel the short-term effects. It seems as though the short term is
actually a very long one.
Not surprisingly, this lag time has engendered a host of critics of such a narrow
monetary policies. Perhaps most notably, P. Krugman has argued that while the belief that
absolute price stability is a 'huge blessing' with large benefits and few drawbacks, the
concept rests entirely on faith. Empirical evidence actually indicates the opposite. The
benefits of price stability are elusive and the costs of achieving it are large. And zero
inflation may not be a good thing even in the long run. Critiques focused specifically on
the Bank of Canada's policy further argue that the Bank has been overly obsessed with
reducing inflation to the detriment of other concerns. Bringing down inflation in the
early 1990s required a harsh contractionary monetary policy, with extremely high
short-term interest rates. For these observers, the Bank's tight monetary policy was
badly mistimed, since it was applied during the recession of the early 1990s and the
precarious recovery that followed. Critics also suggest that the Bank of Canada's policy
surely has important long-run costs. Their argument relates to so-called 'hysteresis',
which refers to the case where a variable that has been shifted by some external force
does not return to its original state once the external force has been lifted. In the
Canadian macroeconomy, it is argued that hysteresis took place when the recession
increased the 'natural' unemployment rate by creating new structural unemployment. As
such, the economy's self-stabilising tendency was hampered which damaged the economy
because its potential level of real output decreased. To some degree, this explanation
helps explain the stubbornly high rates of Canadian unemployment in the 1990s. 
Critics are also quick to point to another important cost of the Bank of Canada's
contractionary policies during the early 1990s. High short-term interest rates have
caused the interest bill on outstanding government debt to increase. And , by pushing
down both real income and employment, the Bank has reduced government tax revenues. A
vicious cycle has been the consequence, with the federal government's added interest
obligations and sagging tax intake forcing it to run higher yearly deficits which have
increased public debt even further. 
Thus, despite the success of reaching low inflation targets, low inflation monetary
policy does tend to raise unemployment, either directly or indirectly. This can occur
through its effects on investment or otherwise, unless the policy generates a great
increase in confidence and public expenditure cuts. As the Canadian case demonstrates,
this may not be possible. The danger of a narrowly focused monetary policy, then, is that
if unemployment rises more than expected, which may well happen, political pressures are
likely to be generated leading to the abandonment of the experiment. In Canada, the
pressure is increasing, and though virtually independent of the government, the Bank of
Canada may not be able to withstand the costs of the experiment for much longer.
Abandoning the policy, however, would also be very costly in that, by undermining
confidence in the authorities' capability and determination, it would make it almost
impossible for the Bank's future policies to have beneficial direct effects on
expectations. The alternative strategy of defining a target path for unemployment, though
liable to be condemned by the public as 'cold-blooded', might minimise this risk and thus
lower the expected unemployment cost of the ultimate reduction of inflation. But, this
too may prove to be different in practice.
Empirical studies have shown that, contrary to the prevailing beliefs of many economists
and central bankers, in the "long run, a moderate steady rate of inflation permits
maximum employment and output. Maintenance of zero inflation measurably increases the
sustainable unemployment rate and correspondingly reduces the level of output." Zero
inflation inflicts permanent real costs that are much larger than envisaged by
present-day policy makers. Following Canada's path to zero inflation, empirical modelling
demonstrates that the instigation of a policy of zero inflation immediately reduces
employment, and it continues to decrease until the third year of the zero inflation
'experiment'. "The effects of wage rigidity mount as inflation approaches zero,
increasing the incremental unemployment cost of reducing inflation further. The zero
inflation rate target is not reached until the 6th year, at which point unemployment has
reached 10.8 percent. Unemployment declines gradually from that point, nearing its steady
state rate of 8.4 percent after a decade." Without much surprise, this does very closely
reflect the effects of the zero inflation monetary policy pursued in Canada. Policy
makers should not be satisfied with an ultimate unemployment rate of 8.4%. Not only is
this rate of unemployment still high, but the costs involved in securing the target are
certainly not worth it. 
Observations and Conclusions
Inflation, both high and low, clearly poses great problems on the macro and micro
economy. In higher doses, inflation erodes people's savings, endangers economic growth
and propagates social instability. So, it has been argued, "why not in these more
disciplined times try to eradicate the disease altogether, just as the world has gotten
rid of smallpox? Why not, some central bankers and economists are asking, aim for zero
inflation - at least in the industrial countries?" 
Only in recent years has this question even been feasible. Previously, if inflation was
single digit, it was quite acceptable. "Now, however, the world is entering an era of low
inflation that brings more ambitious targets within reach. According to the International
Monetary Fund, average inflation in the industrial countries is running at only just over
2 percent a year, and although the rate is much higher in the developing countries, it is
falling quickly." As shown in this study, the proliferation of low inflation monetary
policies to pursue virtual price stability is at the root of this phenomenon. However, as
shown in this paper, zero inflation objectives are not wise: Central banks and
governments may be trying to kill something that is not capable of being made extinct.
This is particularly true in the era of globalisation. "Fiercer global competition and
freer world trade, low oil and commodity prices, the declining power of labour unions,
the growing resistance of consumers to price increases, and the heavy penalties imposed
by financial markets on undisciplined governments" are working to complicate monetary
policies, and further make zero inflation impractical. Thus, even if 'zero' or low
inflation is readily achievable, as it seems to be, it does so in the face of very
powerful variables. 
But, there are several additional reasons to end zero inflation policies. Above all, this
paper has demonstrated that the macroeconomics of low inflation is a delicate science.
Macroeconomic performance is very different when inflation falls lower half of the 1-3
percent range than in the upper-half of the 2-4 per cent range, particularly in the long
run. Numerically small, but effectively huge, differences arise from the sharp
non-linearity of the long-run Phillips curve at low inflation rates. "Wringing the last
drops of inflation out of the system has painful consequences for growth, jobs and
investment that are neither politically acceptable nor economically desirable." Though
central banks are reluctant to see the logic of this argument at the moment, the time may
soon come when the credibility of giving up zero inflation experiments will be greater
than their continued pursuit. A prerequisite to this, in all likelihood, is that the
least unemployment costly path for stabilising prices must be found. And, unfortunately,
this is a difficult, if not impossible, pursuit. 
From all of the confusion, what is clear is that a little inflation, perhaps 1 to 3
percent, is a far more efficient policy choice than zero inflation. Such a moderate
inflation target would allow real wages to decline where necessary without firms having
to impose wage cuts or fire workers. Thus, "rather than misusing their energy pursuing
zero inflation, governments should be exploring the other policy options now available.
In today's low-inflation environment, central banks can afford to be less restrictive
than they have learned to be over the past two decades and allow greater room for growth.
Exchange rates can, if necessary, be nudged downward without automatically provoking the
wage and price spirals they did in the past." Such examples are not necessarily a panacea
for the damage caused by zero inflation experiments so far, but they are certainly less
harmful. As argued by Pierre Fortin, public opinion is starting to reflect the reality
that "promised 'large benefits' from zero inflation are actually a mirage and that the
'small' unemployment costs are actually huge." This opinion has been voiced particularly
loudly by Japan and France. And unless the elusive benefits of zero inflation soon
manifest themselves, it is only a matter of time before the rest of the 'no inflation'
pack realises they are barking up the wrong tree.
BIBLIOGRAPHY
Akerlof, George., Dickens, William., Perry, George., 'The Macroeconomics of Low
Inflation'., Brookings Papers on Economic Activity (1996 NI)
Dale, Reginald., 'Zero Inflation is Not a Great Idea'., International Herald Tribune
(Tuesday, September 10, 1996) 
Fortin, Pierre, 'The Canadian Fiscal Problem: The Macroeconomic Connection' in Lars
Osberg and Pierre Fortin (eds.), Unnecessary Debts (Lorimer, 1996)
Fortin, Pierre., 'The Great Canadian Slump'., Canadian Journal of Economics (November
1996)
Freedman, Charles, 'The Role of Monetary Conditions and the Monetary Conditions Index in
the Conduct of Policy'., in Bank of Canada Review (Autumn 1995)
Friedman, Milton., 'The Role of Monetary Policy'., American Economic Review (March,
1968)
Frisch, Helmut., Theories of Inflation (Cambridge University Press, New York, 1983)
Lovewell, Mark., 'Getting to Zero: Bank of Canada Policy in Context'., in Bank of Canada
Review (Autumn 1996)