The Great Debate

Deflation is a dangerous distraction

November 24, 2008

– John Kemp is a Reuters columnist. The views expressed are his own –

John Kemp Great DebateLONDON, Nov 24 (Reuters) – For the second time in less than a decade, the spectre of deflation is stalking western economies and filling acres of newsprint. But the focus on deflation is based on a misreading of history and risks diverting attention from more pressing problems.

First time around, the mistaken focus on falling prices caused the Federal Reserve to leave interest rates too low too long in 2002-2004, fuelling the surge in U.S. real estate and subprime loans that now threatens to overwhelm the global banking system.

This time, the obsessive focus on deflation threatens to become a distraction from the real problem confronting policymakers: how to stabilise output, employment and home values, rather than worry about marginal and largely theoretical declines in consumer prices that have little impact on the business cycle.


There is a fairly widespread consensus among economists and policymakers that the appropriate target for monetary policy is “price stability”.

Like inflation, deflation is problematic because genuine price signals may be lost amid the noise. But there are at least four reasons why economists are especially concerned about a generalised, sustained fall in prices:

(1) Once deflation becomes embedded in expectations, households and businesses may postpone major purchases of durable goods and capital equipment in the hope of buying them more cheaply later, intensifying the cyclical downturn.

(2) Because wages and salaries are harder to cut than prices for goods and services, nominal wage rates tend to hold up better than prices during a deflationary slump. The result is a perverse increase in real (inflation-adjusted) wage rates encouraging firms to cut even more jobs, intensifying the loss of household income and spending power, at precisely the moment when real wages need to fall to limit the rise in unemployment.

(3) Most debt contracts are fixed in nominal terms (especially for repayment of the principal). As deflation cuts corporate cash flow and household income, the burden of servicing and amortising mortgages, consumer credit and commercial loans rises, increasing the risk of default.

(4) Central banks cannot cut interest rates below zero (the so-called “zero interest rate bound”, ZIRB). In a world of deflation, monetary policy may become ineffective. Even as nominal interest rates are reduced to zero, falling prices make real inflation-adjusted interest rates positive. The faster prices decline, the higher real interest rates become. Deflation can lead to an unintended tightening of monetary policy.

For this reason, most economists prefer a low but positive rate of inflation to a world of static or falling prices. The Federal Reserve and other central banks have mostly defined “price stability” as consistent with a positive inflation rate of 1-3 percent to avoid the operational difficulties created by a world of falling prices.


It is very likely the United States and some other major economies will experience a decline in the general price level over the next twelve months. The massive escalation in food and energy prices that pushed up headline inflation over the last year has now gone into reverse and will now drag down headline inflation rates sharply over the next 12 months.

As recently as mid July, U.S. gasoline prices were still 37 percent higher than prior-year levels; now they are 32 percent below. The massive decline in energy and agricultural prices will probably push the headline rate below zero during H1 2009.

But is this really deflation, in the sense of an ongoing fall in the general price level?

During 2006-2008, policymakers were anxious to shift the focus away from the headline inflation rate to the core rate excluding food and energy items, distinguishing between a one-off adjustment in the price of some items (food and energy) and a more systematic and self-sustaining rise in prices throughout the economy.

Senior Fed officials argued policy should focus on the (much lower) rise in core inflation rather than try to push back against the surge in headline inflation driven by soaring oil and food prices.

In the present circumstances, there is an even stronger case for ignoring the impact of a one-off fall back in oil and food prices to focus on the core rate in the rest of the economy. Core prices are stabilising after a sharp run up in 2006 and 2007, but show no signs of widespread and self-sustaining declines yet.


While problems with the ZIRB, deflationary psychology, and the downward rigidity of both nominal wages and debt contracts are interesting theoretical curiosities, there is not much evidence they have been decisive drivers of downturns in practice. Sharp declines in output, and the associated loss of jobs, incomes and spending power are far more important.

Particularly in the United States and certain other Anglo-Saxon economies, consumers display strong rates of time preference. Recent experience indicates they prize consumption now much more highly than in the future, and have been willing to incur substantial debt to fund purchases now rather than save to buy them later. It seems unlikely consumers would postpone the purchase of autos and other big ticket items for a year or more to benefit from a small 2 or 3 percent reduction in the ticket price.

Heightened fear of unemployment, slower wage growth and loss of valuable overtime have played a much stronger role restraining consumer spending. Retail spending has plunged in the United States and many other countries in September and October at exactly the same time the intensifying banking crisis began to filter through into sharp job losses and fears of a deep recession.

Fears about recession are becoming self-fulfilling as the sharp pull back in consumer spending and business investment causes retailers and manufacturers to pull back, announce store and factory closures, and begin layoffs.


John Maynard Keynes famously wrote about the “paradox of thrift”. But it is hard to blame households for increasing their saving or encourage them to continue spending as the threat of unemployment rises, or to blame businesses for cutting back output and employment to prepare for a downturn in sales. He might as easily have written about the paradox of retrenchment.

To have any chance of averting a deep recession, or at least ameliorating it, policy has to find a way to break this negative feedback loop by guaranteeing output employment levels (at least in aggregate if not for individual households and businesses).

By making a commitment to keep output and employment high, policy can given households and businesses the confidence to continue spending and investing, or at least minimise the amount of retrenchment. In effect, the government provides an “insurance policy”.

Insuring the economy against a prolonged and deep slump will almost certainly require a substantial increase in public spending.

Monetary policy is paralysed by widespread uncertainty about the solvency of households and corporations amid a deteriorating outlook. Tax cuts, the other traditional form of stimulus, are more likely to be saved or used to pay down debts than spent at present.

In contrast, public spending provides an immediate boost to output and employment. More importantly, increased spending, especially on infrastructure, is easier to roll back once the crisis is past, limiting the long-term fiscal damage, unlike tax cuts, which have proved very hard to reverse.

Rather than worrying about a modest decline in the price level, policy needs to focus on guaranteeing households and businesses against the worst aspects of the downturn to minimise the decline in spending and investment. Policies that create demand and jobs, while limiting foreclosures and bankruptcies, rather than fight the deflation chimera or worry about falling asset values are now the urgent priority.

2 comments so far | RSS Comments RSS

Mr. Kemp, I couldn’t agree more. Such policies would mitigate foreclosures,loosen credit and eventually increase demand. My concern is how the folks on the “hill” will respond.

Posted by Anubis | Report as abusive

This is a very well written article. I will be recommending it to many people.

However, I have to say, I am seeing a lot of similarities between your arguments and the arguments of the French politicians written about in A. D. White’s “Fiat Money Inflation in France” (http://mises.org/books/inflationinfranc e.pdf). Obviously the situation is different, but the justification for the recommended policies is shockingly similar. I would think that that similarity was enough for one to consider the long term consequences of policies that provide “an immediate boost to output and employment.”

Posted by paul | Report as abusive

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