What is deflation, what are the risks of deflation, and how can the Fed combat deflation?

May 1, 2003

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 employment.

Deflation Risks

"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 altogether—the preferred scenario—and to fight deflation once it starts—a much more difficult task when an economy slips into a deflationary spiral.

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 demand—a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.

Preventing Deflation

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 seriously—as of course it does—its 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 so
me 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 deflation arise.

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 structure—that 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.1

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.


1. A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly.


"Fear of a Quagmire?" Paul Krugman, New York Times, May 24, 2003..

"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.