FRBSF Economic Letter
2004-08; April 2, 2004
Understanding Deflation
Since the double-digit inflation
of the 1970s, the Federal Reserve has consistently pursued the
goal of price stability in the United
States. And, since the second half of 2002, the year-to-year increase
in the core Consumer Price Index (that is, excluding the relatively
volatile food and energy components) has been below 2%, which,
according to Fed Governor Bernanke, is probably the de facto equivalent
of price stability (Bernanke 2003).
This development in the U.S. economy inflation dynamics is unambiguously
an important achievement. However, last year, as the prospects
for growth remained uncertain, there were concerns that the downward
tendency of inflation might continue, posing a remote, but still
possible, risk that the inflation rate could fall to a level that
is too low. For instance, the balance-of-risks statement issued
at the close of the FOMC meeting on May 6, 2003, recognized explicitly
that the probability of an unwelcome substantial fall in inflation,
though minor, exceeds that of a pickup in inflation from its already
low level.
This Economic Letter examines the distinct features
of deflation, discusses why it is a matter of concern to the public
and to policymakers
in general, and looks at the recent experience of the inflation
and deflation in the U.S. and other countries.
What is deflation?
Let's first be clear about the definition of
deflation. Deflation refers not to falling prices anywhere in the
economy, but to a
decline in the general price level across the economy. In other
words, it is a decline in the price level, not a decline in the
growth rate of the price level. The latter is often referred to
as "disinflation," which means a decline in the rate
of inflation.
It also is useful to be clear that, for the purposes
here, one need not make a strict distinction between the low inflation
and
the deflation. Part of the reason is that, in reality, it is hard
to distinguish between very low inflation and modest deflation.
This is because inflation as measured by regular price indices
is often biased upward; for instance, according to statistical
analysis, the annual inflation rate as measured by core Personal
Consumption Expenditure (PCE) price index is probably biased upward
by about 0.5 percentage point, and the bias can be even a bit higher
when measured by core Consumer Price Index (CPI). Therefore, when
the measured inflation rate is below 1%, one cannot really tell
for sure whether we are experiencing low inflation or modest deflation.
Another,
perhaps more fundamental, reason for not making such a distinction
is that, as the economy swings from low inflation to
modest deflation, the dynamics of inflation and most other aspects
of the economy do not change dramatically. In particular, in examining
the potential costs to the economy, there is no sharp discontinuity
around the switch point. Therefore, one may not need to separate
these two scenarios in discussing the causes or the implications
of deflation.
In thinking of deflation, one should keep in mind
that the term describes only the dynamics of the overall price
level. It does
not imply any specific description of real economic activity. As
a matter of fact, deflation can be accompanied by a weak economy
as well as a by strong economy, and the recent experience of Japan
and Germany illustrate this point. Figure 1 shows that Japan experienced
a contraction in real GDP accompanied by a fall in the Consumer
Price Index in 1998 and early 1999. In contrast, Figure 2 illustrates
that Germany experienced a deflation (or very low inflation) in
1999 and 2000, along with strong real GDP growth. Still, examples
of deflation accompanied by economic strength are rarer in modern
industrialized economies.
What can cause deflation?
Macroeconomists generally agree that,
in the long run, inflation and deflation are monetary phenomena.
However, in the short run,
many factors can push the economy toward deflation. One type of
factor is a positive shock to supply in the economy. For instance,
a positive shock to labor productivity will put downward pressure
on prices. This occurs because nominal wages and salaries are slow
to adjust to unexpected changes in output per hour. With output
per hour rising faster than wages, unit labor costs decline. In
competitive markets, this will induce firms to reduce their product
prices, and the increase in general price level will tend to slow.
For instance, as shown in Figure 3, the productivity surge in the
U.S. in the late 1990s boosted real GDP growth while keeping the
inflation rate on a downward trajectory ("disinflation").
Another example of a positive supply shock might be a decline in
the price of oil. It is possible that if the positive supply shocks
were prolonged, the inflation rate would probably continue to fall
and could eventually lead to deflation, even while, at the same
time, economic growth might be quite satisfactory.
Deflation also
can be induced by negative shocks to aggregate demand. A negative
shock that persistently affects aggregate spending,
such as a continued decline in consumer confidence, will increase
slack in labor and product markets. High unemployment and low capacity
utilization will then cause the inflation rate to decrease gradually
over time, until the economy returns to full employment.
Why is
deflation costly?
Deflation is essentially just the opposite of
inflation. Therefore, the reasons that inflation is costly will
tend to apply also to
deflation. For instance, like an unexpected inflation, an unexpected
deflation will tend to redistribute wealth between borrowers and
lenders when debt contracts are not indexed. Deflation also degrades
the efficiency of the price system as resource allocator and adds
complexity to people's and firms' decisionmaking. It also distorts
the tax treatment of capital because taxation generally uses nominal
income rather than real income as the tax base.
When the economy
is in a prolonged recession, a deflation can be even more costly
than an inflation, as couple of factors may come
into play and worsen the situation. First, if the short-term nominal
interest rate is already low, declining inflation and the Federal
Reserve policy actions to stimulate the economy may eventually
push it toward zero. Because the nominal interest rate cannot be
reduced further, worsening deflation would raise the real interest
rate, effectively tightening monetary policy and discouraging consumption
and investment. Theoretically it may even further reduce aggregate
demand and the general price level, and continue the downward spiral.
Reifschneider and Williams (2000) describe this situation as a "deflation
trap" for monetary policymakers, because the conventional
open-market operations alone will no longer be able to stabilize
the economy.
Second, the labor market adjustment may be more difficult.
During a recession, unemployment is typically higher, as the demand
for
workers is weak. In order to boost employment, nominal wages need
to fall. But workers are typically very resistant to accepting
wage reductions in nominal terms. Therefore real wages tend not
to decline to the level required to "clear the market," and,
as a result the job losses in this situation might be greater than
in a modest inflation. This may prolong the recession on several
counts. It could affect factors like consumer confidence, thereby
weakening aggregate demand. It also could discourage firms from
increasing employment, given that product prices and profit margins
are shrinking.
The situation could get even worse if the financial
sector were fragile. As Bernanke (2003) pointed out, if the balance
sheets
of households and the corporate sector are in poor condition and
if banks are undercapitalized and heavily burdened with nonperforming
loans, deflation would increase the real burden of servicing these
debts, increasing the amount of nonperforming loans and worsening
the balance sheets of both the corporate and the financial sector.
This may "exacerbate financial distress and cause further
deterioration in the functioning of the financial markets." (Bernanke
2003) This process of "debt inflation" played an important
role in the U.S. deflation and depression in 1930s and it probably
also played a role in contemporary Japan.
Tao Wu
Economist
References
[URL accessed March 2004.]
Bernanke, Ben S. 2003. "An
Unwelcome Fall in Inflation?" Remarks
before the Economics Roundtable, University of California, San
Diego, La Jolla (July 23).
http://www.federalreserve.gov/boarddocs/speeches/2003/20030723/default.htm
Reifschneider, David, and John C. Williams.
2000. "Three Lessons
for Monetary Policy in a Low-Inflation Era." Journal of
Money, Credit, and Banking 32(4).
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