CHAPTER 4

The Threat of Deflation

■ A Central Banker’s Worst Nightmare

From a mathematical perspective, inflation and deflation are
two sides of the same coin. Inflation is a period of generally
rising prices. Deflation is a period of generally falling prices.
Both are deviations from true price stability, and both distort
the decisions of consumers and investors.
In inflation, consumers may accelerate purchases before
the price goes up. In deflation, consumers may delay purchases
in the expectation that prices are going down and things will
be cheaper if they wait.
To investors, inflation and deflation are bad in equal, if
opposite, measure. But, from a central banker’s perspective,
inflation and deflation are not equally bad. Inflation is some-
thing that central bankers consider to be a manageable prob-
lem and something that is occasionally desirable. Deflation
is something central bankers consider unmanageable and
potentially devastating. Understanding why central banks
fear deflation more than inflation is the key to understand-
ing central bank monetary policy today.
Central bankers believe they can control inflation by tight-
ening monetary policy. Generally, monetary policy is tightened
by raising interest rates. Since rates can be raised to infinity,
there is not limit on this tool. Therefore, no matter how strong