Slow burn default:Mean reversion is not coming back

Over the last decade it has become the consensus that CBs’ responsibility isto ensure that growth rates do not significantly deviate from the norm and thatannual inflation should approximate a certain arbitrary number (most DMssettled on 2%). However, there has never been a logical reason why it shouldbe at that level, and while there is plenty of evidence that very high inflation isdetrimental, it is not clear that low inflation or mild deflation is negative.

    The textbook answer is that in a climate of low and declining inflation, privatesector delays investment and consumption, and hence, it creates a growth‘headwind’. While it makes intuitive sense, evidence from countries as diverseas Japan, Korea and Germany suggests that the link between low inflation ormild deflation and private sector is far more complex. The best one could sayis that in today’s world of big data and desire to squeeze the ‘last ounce ofjuice’, there is a palpable desire for permanent stimulus. However, by far themost important reason for avoiding low inflation is that the real value of debtincreases in a deflationary climate, thus causing a spike of debt defaults. Byinsisting on a 2%-3% inflation, CBs are engineering a slow-burn default byborrowers. As long as there is another Peter, you can always pay Paul. Athigh levels of leverage, even a mild deflation could stop the merry-go-around.

    Societies have judged such outcomes unacceptable.