“When inflation is already low and the fundamentals of the economy suddenly deteriorate, a central bank should act more pre-emptively and more aggressively than usual in cutting rates.”
Ben Bernanke, the chairman of the Federal Reserve, would be well advised to heed his own advice from 2002. The current environment is more unnerving than the one he described then as a governor of the US central bank. Cutting rates is no longer an option. Inflation is now low and falling in the US and Europe (year-over-year core inflation at 0.9 and 0.8 per cent) and has firmly taken hold in Japan at minus 1.6 per cent year-on-year.
There are sound economic reasons for the persistence of disinflation and the appearance of outright deflation in the aftermath of the 2008 financial crisis. Financial crises are ultimately deflationary because they create a rise in the demand for cash that depresses aggregate demand at a time when substantial excess capacity exists. The excess capacity is created in the run-up to the crisis, when underpricing of risk expedites a substantial build-up in the capital stock.