Downside Danger

If a single proposition unites central bankers these days, it is the belief that price stability -- in practice, a low and stable rate of inflation -- is the bedrock of sound monetary policy. To someone with only a passing knowledge of monetary and economic history, this idea may seem unprogressive, if not downright Victorian. In fact, its validity has been demonstrated, painfully, many times.

There is now a consensus among economic historians that a particular form of price instability -- deflation, or falling prices -- was a principal cause of the Great Depression. And nearly all economists agree that the inflationary surge in the United States, the United Kingdom, and several other countries from the late 1960s through the early 1980s was an important source of the economic volatility, slow growth, and high unemployment that characterized those years.

Determined to avoid a repeat of the Great Inflation of the 1970s, central bankers around the world have worked hard over the last two decades to achieve price stability. The U.S. Federal Reserve has reduced inflation from more than 13 percent in 1979 to the low single digits today. As part of the anti-inflation campaign, many central banks have adopted quantitative inflation objectives, including several banks, such as the European Central Bank (ECB), that do not formally classify themselves as "inflation targeters."

Nearly all industrialized nations currently have inflation rates of around 2 percent, the important exception being Japan, which is experiencing a mild deflation. Even regions traditionally prone to high inflation have substantially reduced their inflation rates. For instance, many countries in Latin America now boast rates well below 10 percent; very few have rates above 20 or 30 percent, a once common level.

Low and stable inflation in many countries is an important accomplishment that will continue to bring significant benefits. But de facto price stability has had another effect, which is now forcing central bankers, as well as the public, to fundamentally rethink inflation.

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