LONDON, March 16 (Reuters) - Any deflation need not last long or have a high economic cost if it is tackled by appropriate monetary policy action and economic flexibility, the Bank of England said on Monday.
The BoE forecast last month that consumer price inflation was likely to significantly undershoot its 2 percent target over the next two years, and policymakers are worrying that inflation could turn negative.
"Deflationary episodes can be short-lived and less costly if policy responds promptly and decisively, employing the full range of conventional and unconventional monetary policy instruments," the BoE said in its quarterly bulletin.
The British central bank started a policy of quantitative easing 10 days ago to boost the money supply and loosen credit conditions by buying assets such as gilts with newly created central bank money.
The article in the BoE's bulletin said past deflation, such as that in the 1930s, offered little guide to likely outcomes now because policymakers' responses were different then, and the cost of deflation itself was sometimes mixed up with that of the broader downturn in demand.
The BoE identified three key areas which would affect the cost of deflation for the economy:
- 'Menu costs' and tax rates:
Falling prices meant firms had to change price lists and consumers had to work out if firms' price cuts represented a particularly good deal or were part of general price falls.
But firms and consumers could benefit if prices fell as British tax allowances are generally not index-linked, and lower inflation also reduced the cost of keeping cash at hand rather than in a savings account.
- Wage flexibility:
If less productive workers are unwilling to accept pay cuts in a deflationary environment, but did accept pay freezes or modest rises in inflationary times, then unemployment is likely to rise faster.
Deflation has been too infrequent in Britain to know how employers and employees will respond.
- Debt deflation:
Firms and consumers with fixed-rate loans will face higher real rates of interest if there is deflation. Also, flexible rates may not be adjusted if banks think the period of deflation will be short and interest rates are close to zero.
"Unconventional" central bank policy, such as that already undertaken by the BoE, could mitigate the problems of zero nominal interest rates, the central bank said. (Reporting by David Milliken; editing by Stephen Nisbet)