Doubtful about Deflation

October 31, 2008 10:00 AM

Suddenly people are worrying about deflation risks to the US economy. While the Fed was quite right to set aside inflation concerns when it lowered its benchmark interest rate this week, recent data on the outlook and the global slowdown does not indicate that we are at risk of deflation. It is unrealistic to think that we are.

First, asset price declines—even large and widespread ones as in US housing markets—almost never result in broader price declines. As I demonstrated in a paper , the bursting of only 2 out of 44 stock or real estate bubbles led to instances of consumer price index (CPI) deflation (and 16 out of 18 prior episodes of deflation in advanced economies were not preceded or accompanied by asset price busts).

This lack of association between burst bubbles and deflation makes sense. For one thing, the challenge for monetary policy is supposed to be that bubbles arise without showing up in broader inflation measures, and that holds equally true on the way down. For another, even though housing and energy prices are falling, health care and education prices (among others) continue to rise, and they make up 20+ percent of GDP. Real wages (i.e., adjusted for inflation) are flat or declining slightly, but nominal wages are not being cut (the "adjustment" in labor markets takes the form of unemployment, not wage declines).

Second, inflation expectations remain well anchored above zero. This can be seen in the level of interest rates on long-duration US Treasuries and on Treasury Inflation-Protected Securities (TIPS), which are measures in part of inflation expectations. If anything, inflation expectations extracted from those measures and surveys rose 0.50 to 0.75 percent over the last 18 months. This rise will probably reverse with the economic slowdown, but that will still leave expectations well above zero. The fact that core inflation and inflation expectations did not increase more when headline inflation (which includes energy) was so high recently again works in reverse, and will keep inflation expectations from being driven down by energy price declines.

Third, and perhaps the main factor behind the stability of positive inflation expectations, is the activist policy regime of the current Federal Reserve. No one has any doubt that they will take policy initiatives to the limits of their capabilities (and beyond) to sustain the economy and prevent deflation. When deflation befell Japan in the mid-1990s, the Bank of Japan's then-leadership gave every opposite indication, stressing the lack of tools available to them, the supposed positive effects of deflation (a la Treasury Secretary Andrew Mellon in 1931), and fulfilling expectations that they would raise interest rates as soon as possible. A public commitment to combat broadly falling prices, which the Bernanke Fed has undertaken, can keep businesses and consumers from falling into a deflationary mindset that becomes self-fulfilling as the BOJ demonstrated under new leadership in 2003.

Yes, deflation is a bad state to be in, and difficult to end when it gets going in an economy. But there is no good reason to be distracted by that right now. Not only is it unlikely, it is moot: the Fed is already undertaking all of the policies it can right now to provide liquidity to markets, to induce credit expansion, and to lower effective interest rates. If more pessimistic forecasts are to be believed, the US and global economies are facing a severe slowdown in growth and employment, and that is reason enough to take action—or rather to continue with the course of aggressive policy actions already underway. Talking about deflation just adds to fear without either a convincing basis or constructive implications for policymaking.

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Adam S. Posen Senior Research Staff

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