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Deflation?!

June, 2003

For three decades central bankers have struggled to push inflation lower, but some are now starting to wonder whether falling prices might be the bigger threat today.

In early May, America's Federal Reserve said that a further fall in inflation would be unwelcome. Meanwhile, the European Central Bank (ECB) lifted the floor of its inflation target. In other words, both central banks were admitting that inflation can be too low.

Japan has been suffering from deflation (a fall in the general price level) since the mid-1990s, but now there are fears that the disease could spread to America and Europe. America's core rate of consumer-price inflation (excluding food and energy) has fallen from 2.8% in late 2001 to 1.7% in March, its lowest since 1966. The euro area's core inflation rate has fallen from 2.6% to 1.7% in the past 12 months.

Thanks to overinvestment during the bubble years of the late 1990s and to current sluggish demand, the world is awash with excess capacity in industries from telecoms and airlines to banking and cars, putting downward pressure on prices. Even if a recession is avoided, economic growth looks likely to remain below trend this year almost everywhere; so output gaps (the difference between countries' actual and potential GDP) will widen. The euro area's feeble start to the year (the GDPs of both Germany and Italy shrank in the first quarter) suggests that the single-currency zone will see an even bigger increase in its output gap than America has. Even if growth returns to trend next year, the gaps will remain large.

Historically there has been a close relationship between the size of the output gap and the direction of change in inflation (see chart). When the output gap is negative (actual output is below potential), as at present, inflation usually falls. With inflation already low, a further two years of decline could easily end in deflation. Economists at Dresdner Kleinwort Wasserstein forecast a core inflation rate of just above 1% in America at the end of next year, and of only 0.2% in the euro area. They expect that by then consumer prices will be falling in both Germany and France.

The fact that neither the Fed nor the ECB cut interest rates at their policy meetings in early May suggests that they are more sanguine about the risk of deflation. Wim Duisenberg, the ECB's president, said that he did not expect headline inflation to fall below 2% until the end of this year. Yet several private-sector forecasters reckon that the stronger euro and higher unemployment could reduce inflation to close to 1% by early next year. That would be well below the ECB's newly clarified inflation goal of less than, but close to, 2%. The ECB's previous target was "less than 2%", but its new goal is still too low. Most central banks have targets with mid-points of 2.5%.

Deflation is not always bad. If caused by rapid productivity growth, as in the late 19th century, it can go hand in hand with robust growth. But if prices are falling because of a slump in demand, deflation can be dangerous. Today the world exhibits both sorts of deflation, but the vast amount of excess capacity suggest that most of it is the bad sort.

Deflation is particularly harmful when an economy has lots of debt, because falling prices swell the real debt burden. This can lead to a vicious circle: as heavily indebted firms are forced to reduce costs, jobs and spending are cut across the economy, pushing prices lower still. In both America and the euro area, total private-sector debt today is larger as a share of GDP than it was when deflation last haunted the world in the 1930s-though not as high as in Japan a decade ago.

The biggest economic danger is that, because nominal interest rates cannot go below zero, deflation makes negative real interest rates unattainable. But then these may be needed to drag an economy out of recession. Last year a study by economists at the Fed of Japan's slide into deflation concluded that monetary policy was not too tight in the early 1990s, given the outlook at the time for growth and inflation. But those forecasts proved too optimistic, and by then it was too late to act. The lesson is that as interest rates and inflation move closer to zero, central banks need to cut interest rates more forcefully than would normally be called for by forecasts of growth and inflation. This justifies the Fed's aggressive easing over the past two years. The ECB's recent behaviour suggests that it has not read the Fed study.

American interest rates (1.25%) are lower than the euro area's (2.5%), which might suggest the Fed is running out of ammunition. But both the Fed and the ECB need to cut interest rates further if they are to be sure of avoiding deflation. But what if deflation takes hold and interest rates hit zero? Late last year, Ben Bernanke, a governor of the Fed, flagged a range of alternative measures that could be used:

• A central bank can reduce long-term interest rates. One way would be to announce that it will hold short-term rates at zero for an extended period. Long-term rates, which depend upon expected future short-term rates, would then fall.
  
  

• A more effective way to reduce long-term rates is for the central bank to buy government bonds. This is Mr Bernanke's preferred cure, but it has not stopped deflation in Japan, where long-term bond yields are 0.6%. Mr Bernanke blames Japan's defective banking system and a lack of determination by policymakers to fight deflation. There is some truth in this, but another reason why the policy has failed to boost spending is that overindebted households and firms prefer to save and repay debt. Given the huge excesses left after America's bubble, the same might happen in the United States.
  
  

• As well as government bonds, a central bank could buy private securities to pump in more liquidity. This might require a change in the law in some countries.
  
  

• Foreign-exchange intervention, to push down a currency, could help to boost output and raise import prices. The most striking example of this was the devaluation of the dollar in 1933-34, which helped to end deflation. This would work for a single country, but it is not an answer to global deflation: not every country can devalue. A falling dollar will reduce the risk of deflation in America, but push inflation lower in the euro area and Japan.
  
  

• Last but not least, a central bank can print money to finance tax cuts or higher public spending. This is the surest method of halting deflation, but it is not foolproof. Tax cuts might be saved, not spent, by debt-ridden consumers, so an increase in public spending could be more effective. But, as in Japan, there is then a risk that money is channelled into politically favoured projects with low returns.

In a serious bout of deflation, a central bank acting alone may fail to halt deflation, but if a central bank and government act jointly they will surely succeed. However, a money-financed fiscal stimulus requires co-ordination between the government and the central bank-something that newly independent central banks find hard to do. This has been a big stumbling-block in Japan; such co-ordination would be even harder to achieve in the euro area, where there is the extra complication of the stability and growth pact.

Mr Bernanke believes that, if a central bank injects enough money, it can always reverse deflation. Implicit in this is the view that Japan's persistent deflation reflects the Bank of Japan's incompetence, and that the Fed would do a better job. Is this right? Policy errors are partly to blame for Japan's plight, but the awkward fact is that post-bubble economies tend to be prone to deflation. The Fed may find it harder than it thinks to escape the deflation monster. As for the ECB, its recent behaviour gives little cause for confidence that it would act swiftly.

Courtesy of: http://www.economist.com