What is deflation, what are the risks of deflation, and how can the
Fed combat deflation?
With the U.S. inflation rate moving closer to zero and the economy hitting
a "soft patch" in late 2002 and the first half of 2003, there
has been a surge of interest in deflation. Japan's ongoing period of deflation
and associated weak economic performance also fuels concern. Deflation,
defined as a generally falling price level, is represented in the chart
below by time periods when the Consumer Price Index (CPI) change was negative.
The chart shows that deflation has been a relatively rare occurrence in
the U.S.; the most serious period of deflation in the past 80 years in
the U.S. occurred in the early 1930s during the Great Depression. Despite
several recessions since the 1930s (shown on the chart as the shaded gray
bars), the last time the CPI actually declined for a short period was
in the 1950s.
Low Probability of Deflation
In 2003 most economists consider deflation a low probability event.
However, the slow economic expansion from late 2002 through mid-year 2003
raises the risk that the economy could slip into a period of deflation
in the event of a significant negative economic shock. Concern arises
because the potential for deflation to have significant negative effects
on the economy is high. Also, there is a risk that even lowering interest
rates to zero would not be enough to drive the economy back up to full
"In other words, deflation discourages borrowing and spending,
the very things the depressed economy needs to get going."
-Economist Paul Krugman
Deflation creates incentives to save and postpone spending because prices
will be lower and purchasing power greater in the future. This pattern
depresses spending and weakens the economy. At the same time, deflation
worsens repayment burdens for borrowers, because the burden of repaying
debt increases with deflation. This is because debts remain fixed in dollar
terms, but wages and income typically fall during deflations. Japan presents
an ongoing example of the ill effects of deflation on a nation's economic
performance. (See International Finance Discussion Papers, "Preventing
Deflation: Lessons from Japan's Experience in the 1990s.")
Chairman Greenspan's December 19, 2002, speech titled, "Issues
for Monetary Policy,"
presents additional information on the important negative effects
deflation has on debtor's financial health and labor market conditions:
A Shift in Focus
prevention of deflation is preferable to cure."
-Federal Reserve Governor Ben S. Bernanke
After years of successful efforts to bring down the rate of inflation
in the U.S. economy, in late 2002 policymakers expressed concerns about
another challenge: deflation. Federal Open Market Committee members also
raised the issue in their May
6, 2003 Statement when they wrote that the economy faced a small,
but real, prospect of deflation. This change in focus was in part driven
by the combination of a low U.S. inflation rate and a weak economy. Meanwhile,
policymakers already were exploring policies designed to avoid deflation
altogetherthe preferred scenarioand to fight deflation once
it startsa much more difficult task when an economy slips into a
Deflation: Making Sure "It" Doesn't Happen Here
Federal Reserve Governor Ben S. Bernanke helped focus policymakers
and economists on the issue of deflation with his November 21, 2002 speech
on the subject. His remarks titled, "Deflation:
Making Sure "It" Doesn't Happen Here," were given
at the National Economists Club in Washington, D.C. His comments were
widely reported in the press and focused on several ways to combat deflation.
The following excerpts from Governor Bernanke's speech:
- define deflation in detail,
- discuss the importance of preventing deflation,
- examine the likelihood of deflation, and
- describe some potential policies for fighting a deflation if it takes
hold of an economy.
Excerpts from Governor Bernanke's Speech:
Deflation and Its Causes
Deflation is defined as a general decline in prices, with emphasis
on the word "general."
Deflation per se occurs only
when price declines are so widespread that broad-based indexes of prices,
such as the consumer price index, register ongoing declines.
The sources of deflation are not a mystery. Deflation is in
almost all cases a side effect of a collapse of aggregate demanda
drop in spending so severe that producers must cut prices on an ongoing
basis in order to find buyers.
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. Beyond this commonsense injunction,
however, 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.
Second, the Fed should take most seriouslyas of course
it doesits responsibility to ensure financial stability
in the economy.
Third, as suggested by a number of studies, when inflation is
already low and the fundamentals of the economy suddenly deteriorate,
the central bank should act more preemptively and more aggressively
than usual in cutting rates.
Evaluating the Prospect of Deflation
As I have indicated, I believe that the combination of strong economic
fundamentals and policymakers that are attentive to downside as well
as upside risks to inflation make significant deflation in the United
States in the foreseeable future quite unlikely. But suppose that, despite
all precautions, deflation were to take hold in the U.S. economy and,
moreover, that the Fed's policy instrument-the federal funds rate-were
to fall to zero. What then?
Policy Choices for Curing Deflation
In the remainder of my talk I will discuss some possible options
for stopping a deflation once it has gotten under way. I should
emphasize that my comments on this topic are necessarily speculative,
as the modern Federal Reserve has never faced this situation nor has
it pre-committed itself formally to any specific course of action should
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 cooperating with the fiscal authorities.
So what then might the Fed do if its target interest rate, the overnight
federal funds rate, fell to zero? One relatively straightforward extension
of current procedures would be to try to stimulate spending by lowering
rates further out along the Treasury term structurethat is,
rates on government bonds of longer maturities.
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.
Options for Fiscal Policy
Each of the policy options I have discussed so far involves the Fed's
acting on its own. In practice, the effectiveness of anti-deflation
policy could be significantly enhanced by cooperation between the
monetary and fiscal authorities. A broad-based tax cut, for example,
accommodated by a program of open-market purchases to alleviate any
tendency for interest rates to increase, would almost certainly be an
effective stimulant to consumption and hence to prices.
Of course, in lieu of tax cuts or increases in transfers the government
could increase spending on current goods and services or even acquire
existing real or financial assets.
"Fear of a Quagmire?" Paul Krugman, New York Times, May
"Preventing Deflation: Lessons from Japan's
Experience in the 1990s," Alan Ahearne, Joseph Gagnon, Jane Haltmaier,
Steve Kamin, International Finance Discussion Papers. Federal Reserve
Board of Governors, 2002-729 (June 2002
"Deflation: Making Sure "It" Doesn't
Happen Here." Remarks by Governor Ben S. Bernanke before the National
Economists Club, Washington, D.C., November 21, 2002.
"Issues for Monetary Policy." Remarks
by Chairman Alan Greenspan before the Economic Club of New York, New York
City, December 19, 2002.