Deflation: Making sure ‘it’ doesn’t happen here

(The author is a governor of the U.S. Federal Reserve Board.)

Since the Second World War, inflation — the apparently inexorable rise in the prices of goods and services — has been the bane of central bankers.

Economists of various stripes have argued that inflation is the inevitable result of (pick your favourite) the abandonment of metallic monetary standards, a lack of fiscal discipline, shocks to the price of oil and other commodities, struggles over the distribution of income, excessive money creation, self-confirming inflation expectations, an “inflation bias” in the policies of central banks, and still others.

However, during the 1980s and 1990s, despite widespread “inflation pessimism,” most industrial-country central banks were able to cage, if not entirely tame, the inflation dragon. Although a number of factors converged to make this happy outcome possible, an essential element was the heightened understanding by central bankers, political leaders and the public at large of the high costs of allowing the economy to stray too far from price stability.

Today, with inflation rates now quite low in the United States, some have expressed concern that we may soon be facing a new problem — the danger of de-flation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation — a decline in consumer prices of about 1% per year — has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors. While it is difficult to sort out cause from effect, the consensus is that deflation has been an important negative factor in the Japanese slump.

So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons.

The first is the resilience and structural stability of the U.S. economy itself. Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, recover, and continue to grow. Flexible and efficient markets for labour and capital, an entrepreneurial tradition, and a general willingness to tolerate and even embrace technological and economic change all contribute to this resiliency. A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are, for the most part, in good shape.

The second bulwark against deflation in the United States is the Federal Reserve System itself. Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation, as well as inflation. I am confident the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in co-operation with other parts of the government, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.

The sources of deflation are not a mystery. It is, in almost all cases, a side-effect of a collapse of aggregate demand — a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending — namely, recession, rising unemployment, and financial stress.

However, a deflationary recession may differ in one respect from “normal” recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or close to zero. Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the “zero bound.”

Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be.

Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value.

When William Jennings Bryan made his famous “cross of gold” speech in his 1896 presidential campaign, he was speaking on behalf of heavily mortgaged farmers whose debt burdens were growing ever larger in real terms — the result of a sustained deflation that followed America’s post-Civil-War return to the gold standard.

Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has “run out of ammunition.” It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory.

However, a central bank, either alone or in co-operation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.

As I have already emphasized, deflation is generally the result of low and falling aggregate demand. The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation. In other words, the best way to get out of trouble is not to get into it in the first place.

But beyond this common-sense injunction, there are several measures that the Fed (or any central bank) can take to reduce the risk of falling into deflation.

First, the Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero. For example, central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1% and 3% per year.

Second, the Fed should take most seriously — as of course it does — its responsibility to ensure financial stability in the economy. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the Sept. 11, 2001, terrorist attacks.

Third, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more pre-emptively and more aggressively than usual in cutting rates.

As I have mentioned, some observers have concluded that when the central bank’s policy rate falls to zero — its practical minimum — monetary policy loses its ability to stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistak
en. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in co-operation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for US$300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is, to any degree, efficient, the price would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of the yellow metal.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many dollars as it wishes at essentially no cost. By increasing the number of dollars in circulation, or even by credibly threatening to do so, the government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Of course, the U.S. government is not going to print money and distribute it willy-nilly. Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system — for example, by making low-interest-rate loans to banks or co-operating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. However, if we do fall into deflation, we can take comfort in knowing that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it’s worth noting that there have been times when exchange-rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt’s 40% devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year over year, went from minus 10.3% in 1932 to minus 5.1% in 1933 to 3.4% in 1934. The economy grew strongly, and, by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.

The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation?

First, as you know, Japan’s economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.

Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan’s overall economic problems. In the resulting political deadlock, strong policy actions are discouraged and co-operation among policymakers is difficult to achieve.

Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of serious deflation occurring in the United States appear remote indeed, in large part because of our economy’s underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures.

— The preceding is an edited version of his speech to the National Economists Club in Washington, D.C. The rest of the speech can be found at www.federalreserve.gov