Dr Strangelove and the threat of deflation
Fear of deflation haunts investors and stalks the halls of the Federal Reserve in Washington.
But how bad are declining prices, and why have they become a problem? Should investors and the Fed stop worrying and learn to love deflation, at least at moderate levels?
For 70 years, deflation was a distant threat as policymakers and economists wrestled with the problem of taming high and persistent inflation rates instead. It started to become an issue in the 1990s when inflation dipped below 3 percent for the first time in three decades, sparking a debate about “optimal inflation rates” and how the Fed should define its price stability mandate.
Eventually a consensus emerged in favour of targeting a low but positive rate of inflation rather than either zero (absolute price stability) or declining prices (deflation). In the United States, the Fed has in practice defined price stability as an increase in non-food and energy prices somewhere between 1.5 and 2.25 percent per year.
Proponents cite “nominal rigidities” in wages and prices, interest rates and debt contracts as the reason to favour a non-zero rate of price rises. Inflation gives policymakers and businesses much needed flexibility to cut real wages, prices, interest rates and the debt burden when it is difficult to reduce them further in cash terms. Small amounts of inflation “oil the wheels” of the economy.
In contrast, deflation is tarred by association with periods of severe economic distress and widespread unemployment during the 1930s and between 1870 and 1895, as well as the more recent experience of Japan in the lost decades of the 1990s and 2000s.
IS DEFLATION SO BAD?
But it is far from clear that deflation caused or significantly contributed to the joblessness and malaise in any of these episodes, or whether it was just a symptom.
In their magisterial “Monetary History of the United States”, Milton Friedman and Anna Schwarz pinned the blame for the Depression on the Fed’s failure to prevent bank failures, not falling prices. Friedman and Schwarz argued the Fed should have done more to provide liquidity to save the banking system, not because it would have stopped prices falling.
The idea that prices should trend upwards over time is relatively recent. Persistent inflation dates from the 1940s.
Before that, periods of inflation had alternated with falling prices with no discernible long-term trend. Deflation has often been the norm, not the exception. In many cases it has been associated with technological innovation, the opening up of new resources, productivity gains and rising living standards.
The late 1990s and early 2000s saw an extensive debate that sought to distinguish “bad” deflation stemming from credit contraction and debt from “good” deflation stemming from productivity gains and technological change.
STICKY PRICES ADJUST
Nor is it clear the “nominal rigidities” identified by Nobel Laureate Paul Krugman and others are so sticky in practice.
As inflation has fallen close to zero, once-unthinkable cuts in wage and salary rates have become more common as an alternative to job losses. It is also possible to push interest rates negative through the use of account maintenance fees and transaction charges. Many customers in the United States, the United Kingdom and elsewhere are already getting negative rates on current accounts once fees are taken into consideration.
There is nothing to stop policymakers from imposing a fee on excess reserves or even required reserves held with the Federal Reserve, or commercial banks from imposing similar fees on their customers. It might not be customary, but it is not impossible. It is no more radical than some of the unconventional monetary policies that have been tried since 2007.
Even on the vexed issue of debt contracts, there is in principle no reason why future contracts could not be indexed to take account of both price increases and price falls. Even on existing contracts, there is no reason in principle why moderate rates of inflation (which punish savers) should be preferable to moderate rates of deflation (which punish borrowers). It is simply a question of redistribution.
DYNAMIC STABILITY IS KEY
The key word here is “moderate”. In the same way inflation may not be a problem provided it is limited to a few percentage points per year, deflation is also unlikely to present major difficulties so long as it remains moderate. Fear of deflation is rooted in the idea that even “moderate” price declines would quickly propagate into an accelerating deflationary spiral as consumers postpone purchases and defaults become epidemic.
But where is the evidence for this? There is no empirical evidence that customers put off buying new durables just because prices are expected to fall 1-2 percent over the next 12 months. Nor do small wage cuts trigger widespread defaults. Almost all defaults and bankruptcies stem from job loss, illness and family breakdown. Low rates deflation should not be more dynamically unstable than low inflation.
None of this is meant to suggest deflation is good. But it is meant to challenge the groupthink that has taken hold among policymakers and economists that inflation of 0-3 percent is somehow a good thing, while price declines of 0-3 percent per year would represent a catastrophe.
CAREFUL WHAT YOU WISH FOR
The increased “risk” of deflation is actually the logical consequence of policies pursued over the last 30 years to bring down inflation and liberalise the economy. They include restrictions on union power, liberalisation of trade barriers, outsourcing to emerging markets and measures permitting higher rates of immigration to increase the supply of workers.
Chart 1 shows the 12-month inflation rate in the United States since 1958 for all consumer prices as well as the core rate excluding volatile food and energy items. Chart 2 shows the annualised volatility in the inflation rate.
Inflation is lower and less volatile than in the late 1970s and early 1980s. But it is not completely predictable or controllable. Bank of England Governor Mervyn King has repeatedly emphasised it is neither possible nor desirable to ensure inflation never deviates from target.
When the inflation rate was 10 percent and varied by +/- 3 percent a year, a 3 percent undershoot simply meant less inflation. But when inflation is lowered to 1.5-2.0 percent, even a 2 percent undershoot means deflation, at least for a time. If the Fed and investors want to eliminate this risk, they will have to start targeting a higher core inflation rate of 3 percent or even 4 percent.
The deflation scenario has arisen because policymakers are targeting a core inflation rate too close to zero. But the policies that have been used to break wage-price spirals in the past may now make it hard to push the inflation rate back up even if the Fed wanted to.
In the 1970s and 1980s, headline inflation and the core rate tracked one another very closely (both in absolute terms and volatility). If inflation began with commodity prices, union bargaining power and relatively closed manufacturing systems ensured it was quickly propagated to the rest of the economy.
In the 1990s and 2000s, the demise of union power and greater openness to trade have broken the link. Workers and manufacturers no longer have enough pricing power to push through wage and price increases to compensate for the soaring cost of oil and raw materials.
It has made it very difficult for the Federal Reserve and other major central banks to create inflation or stave off inflation. Loose monetary policy can fuel sharp rises in the price of internationally traded commodities when emerging market demand is strong and producers wield strong pricing power. But it is not able to generate inflation in the price of manufactured goods or rising wage rates.
Like Dr Strangelove, perhaps it is time to stop worrying and learn to love a little deflation, because there may not be much the Fed can do to prevent it.