Dangerous reality of a zero percent inflation rate

We all know that high inflation rate affects every single one of us, and it is the most common topic people complain about. But is inflation necessary? Why can’t we have stable prices all the time? Ultimately, having a dream world of zero percent inflation.

Is zero percent inflation even possible?

Inflation vs Deflation

Before we start talking about zero percent inflation, you must know that there is inflation when prices rise and deflation when prices fall a lot. A small amount of inflation is considered good for everybody, but deflation of any kind is not beneficial for anybody.

As a consumer, steady prices and zero inflation seem like the ideal. Consumers want to buy the same product for the same price tomorrow, keeping the purchasing power of their money the same. But no matter what happens, governments and their central banks avoid letting inflation get too low.

Why zero percent inflation is not possible?

The primary reason we cannot have zero percent inflation is because the governments and central banks of the countries do not want it. You have probably seen economic experts say that a little inflation is good.

This little inflation is every government’s inflation target. The inflation target is the minimum inflation the government wants to maintain. It is usually at 2%, and some countries have 3-4%. This 2% number is crucial, and if inflation falls below this number, then it is an alarm sign.

Inflation and interest rates

If there is a lot of inflation, the government can control it by increasing interest rates, but if there is deflation, the government cannot do anything.

If the government wants more economic activity, then they might cut interest rates, and there will be more economic activity. When the government cuts interest rates, it makes borrowing money through credit cards and all bank loans cheaper. People can borrow more and spend more, and because of this, there is more economic activity in the country. 

If the government wants to decrease inflation, then it raises the interest rate and makes borrowing such as credit cards, mortgages, etc. more expensive. Because of this, people tend to spend less, which reduces economic activity and results in a decrease in inflation. This is how the government controls inflation with interest rates.

But why does the government not even want zero percent inflation?

Governments generally do not aim for zero percent inflation because a small, positive inflation rate is considered beneficial for the economy. This positive, small inflation is also known as the virtuous inflation cycle.

Inflation cycle

When the prices of goods are generally rising, people expect the prices to rise further. So, it encourages them to buy now instead of paying more for the same product. Usually, these purchases are for big products like cars and houses. Your daily needs for products will also see the price rise over time. Because of this, companies make more money, which ultimately results in more people having jobs and more money to spend. This causes more demand, and the small price rise continues. This cycle continues and is considered healthy for the economy.

Now, if the price rise stops or remains the same, instead of buying it immediately, people will avoid buying it or will hope for the price to fall. This will create less demand for the product and, ultimately, less profit for the company. Less profit means companies will lay off workers, and there will be fewer jobs. Fewer or no jobs mean less spending, which will ultimately result in manufacturing the products at a profit impossible. Now this starts a vicious cycle of deflation.

Now, why does the government aim for a minimum 2% inflation target?

The main reason for it is that the overall inflation is calculated considering lots of factors, and it fluctuates a lot over time. Now suppose if the inflation falls below 2%, then we are more likely  going towards deflation.

History of inflation

In history, the inflation was below 2% many times, especially from 1929 to 1939, it was most of the time below 2%, but that period we know as the Great Depression. Then World War 2 came, and from 1946 to the year 2000, the inflation was in the range of 5-20%.

But during the year 2001, the inflation fell below 2% to 1.4%. We all know that was a dot-com bubble era and economic crisis. Similarly, during the 2008 crisis, the inflation was around 0.1%. And the last time when the inflation was below 2%, it was during the pandemic in 2020 as governments implemented lockdowns and social distancing. The inflation in that period fell below 2%. As inflation fell below the inflation target, the government reduced the interest rate to 0.25%.

Till July 2022, the Fed kept the interest rate low. Once the inflation had increased to 9% in July 2022 after that FED started to increase the interest rate. Once the inflation level came down below 4% in June 2023, the Federal reserve increased the interest rate to 5.33% to this day they kept it the same.

If inflation hadn’t risen, then the government would have very limited options such as negative interest rates, printing money, or giving stimulus checks to citizens to increase spending. Basically the government would have tried everything to bring economic activity in the country.

Conclusion

So, you cannot have 0% inflation as it usually means a small fluctuation will lead to a deflation and an economic crisis. So, the government maintains the 2% inflation as the bottom to have a buffer zone from deflation. That’s why all economist say “a little inflation is always good”

During 2020, when the interest rates were low, many people took advantage of this opportunity and refinanced their home loans, car loans, business loans etc. These people knew how interest rates work and they benefited from it. If you know such things then you can also benefit from it.

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