Deflation, a demon from the distant past or a real danger now ?

During the summer of 2009, Belgium and the euro area, as well as other industrialised countries, recorded negative inflation rates. Although they were the direct result of sharply falling commodity prices in the second half of 2008, policy-makers and the general public wondered whether this would be the start of a deflationary spiral. Indeed, parallels with the Great Depression in the 1930s – which was also characterised by an asset price boom-bust cycle and banking stress – were drawn. The article explains why deflation can have dramatic consequences for the economy, gauges the current deflationary risks and discusses what the policy options are in a deflationary environment. In past centuries, deflation – when defined in a broad sense as a decline in the general price level – was a frequent phenomenon and was not always accompanied by economic hardship. When deflation is defined more narrowly as a sustained decline in the general price level that gives rise to further expected falls, it is no innocent phenomenon since it confronts an economy with a number of nominal rigidities which can trigger a deflationary spiral. One such rigidity is the lower bound on nominal interest rates which can limit the central bank’s potential to stimulate the economy as real interest rates cannot fall any further. Second, the real burden of outstanding debt increases when prices fall, leading to a redistribution of wealth towards lenders who generally have a lower propensity to consume than borrowers. Third, because of money illusion, it is difficult to cut nominal wages, making the adjustment of real wages to a worsened economic situation difficult or even impossible. As shown by available indicators, risk of deflation in the euro area seems limited. The observed negative inflation rates are not a sign of widespread price falls. Inflation expectations remain in check although inflation is expected to return rather slowly to levels consistent with price stability. Taking a broader view, the IMF deflation vulnerability indicator, which combines a range of macroeconomic indicators, shows an increased risk of deflation in all industrialised countries. Having a quantitative definition of price stability that defines the latter as a low, but strictly positive rate of inflation – as the Eurosystem has –, helps to prevent deflation. Yet, when confronted with a deflationary threat, monetary policy has a range of tools to tackle deflationary risks. First, nominal policy rates can be lowered aggressively, until they hit the lower bound. If further stimulus is warranted after rates have been brought close to zero, central banks can resort to unconventional monetary policies, as they have done in previous months. Also fiscal policies can help to contain deflationary risks, especially to tackle banks’ solvency problems if they threaten financial stability, provided that the longer-term sustainability of public finances remains intact. Finally, it must be emphasised that policy-makers have to decide on appropriate policies to deal with deflationary risks in real time.deflation, Great Depression, monetary policy

The Difficulty of Discerning What's Too Tight: Taylor Rules and Japanese Monetary Policy

Observers have relied increasingly on simple reaction functions, such as the Taylor rule, to assess the conduct of monetary policy. Applying this approach to deflationary or near-zero inflation environments is problematic, however, and this paper examines two shortcomings of particular relevance to the Japanese case of the last decade. One is the unusually high degree of uncertainty associated with potential output in an environment of prolonged stagnation and deflation. Consequently, reaction function-based assessments of Japanese monetary policy are so sensitive to the chosen gauge of potential output as to be unreliable. The second shortcoming is the neglect of policy expectations, which become critically important as nominal interest rates approach zero. Using long-term bond yields, we identify five episodes since 1996 characterized by abrupt declines in Japanese inflation expectations. Policies undertaken by the Bank of Japan during this period did little to stabilize expectations, and the August 2000 interest rate increase appears to have intensified deflationary concerns.Deflation, Monetary Policy, Policy Rules, Taylor Rule, Japan

Money, Inventories and Underemployment in Deflationary Recessions

This paper investigates monetary shocks and the rôle of inventories with respect to the occurrence of deflationary recessions. We propose a non-tâtonnement approach involving temporary equilibria with rationing in each period and price adjustment between successive periods. By amplifying spillover effects inventories imply that, following a restrictive monetary shock, the economy may converge to a quasi-stationary Keynesian underemployment state, in which case money is persistently non-neutral. Contrary to conventional wisdom, this is favored by sufficient downward flexibility of the nominal wage. The model is applied to the current deflationary Japanese recession, and we propose an economic policy to overcome itInventories, non-tatonnement, price adjustment, non-neutrality of money, deflationary recession

Liquidity Traps, Learning and Stagnation

We examine global economic dynamics under learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy, the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome we recommend augmenting normal policies with aggressive monetary and fiscal policy that guarantee a lower bound on inflation. In contrast, policies geared toward ensuring an output lower bound are insufficient for avoiding deflationary spirals

Incentives and the Limits to Deflationary Policy

I study a version of the Lagos-Wright (2005) model for which the Friedman rule is always a desirable policy, but where implementation may be constrained by the need to respect incentive-feasibility. In the environment I consider, incentives are distorted owing to private information and limited commitment. I demonstrate that a monetary economy can overcome the former friction, but not necessarily the latter. When this is so, there is an incentive-induced lower bound to the rate of deflation away from the Friedman rule. There are also circumstances in which the best incentive-feasible monetary policy may entail a strictly positive rate of inflation. This will be the case, for example, if agents are sufficiently impatient or if there are rapidly diminishing returns to production.

Monetary and Fiscal Policy to Escape from a Deflationary Trap

This paper provides a theoretical overview of monetary and fiscal policy with the potential to engineer an exit from a deflationary trap, which we define here as sustained deflation in the presence of zero interest rates. We find that the required policy steps are an interest rate hike, a commitment to future currency growth, and a money-financed tax cut. The amount of tax cut required is equal to the increase in the central bank's payments to the treasury resulting from the higher inflation rate (nominal interest rate), while fiscal policymakers must maintain fiscal discipline by stabilizing government debt and the primary balance. There will be a temporary fall in output when prices are sticky, but this is the price that must be paid to conquer deflation. The current commitment to quantitative easing is based on the assumption that the natural interest rate has temporarily declined. If the economy is in a deflationary trap, however, the continuation of zero interest rates reinforces deflationary expectations and may make it perpetually impossible to eliminate deflation. Even under conditions in which the natural rate of interest seems to be positive, if deflation persists, it is probably wise to consider a policy approach that assumes deflationary trap conditions. With this in mind, we believe the conditions required for abandoning the current policy regime should include, in addition to consistently positive growth in the consumer price index (CPI), a consideration of the trend in real GDP.

The Stagnation Regime of the New Keynesian Model and Current US Policy

In Evans, Guse, and Honkapohja (2008) the intended steady state is locally but not globally stable under adaptive learning, and unstable deflationary paths can arise after large pessimistic shocks to expectations. In the current paper a modified model is presented that includes a locally stable stagnation regime as a possible outcome arising from large expectation shocks. Policy implications are examined. Sufficiently large temporary increases in government spending can dislodge the economy from the stagnation regime and restore the natural stabilizing dynamics. More specific policy proposals are presented and discussed.Stagnation, fiscal and monetary policy, deflation trap.

Monetary Policy and Asset Price Volatility

We explore the implications of asset price volatility for the management of monetary policy. We show that it is desirable for central banks to focus on underlying inflationary pressures. Asset prices become relevant only to the extent they may signal potential inflationary or deflationary forces. Rules that directly target asset prices appear to have undesirable side effects. We base our conclusions on (i) simulation of different policy rules in a small scale macro model and (ii) a comparative analysis of recent U.S. and Japanese monetary policy.

Deflationary Expansion : an Overshooting Perspective to the Recent Business Cycle in China

Deflationary expansion has puzzled economists both in and outside China. We study this business cycles phenomenon within a model of discrete time dynamics. We find that deflationary expansion could be possible if driven by an overshooting in investing and if the state of the economy maintains high rate of growth. This expression is consistent with the recent variables. The high steady state of growth could be explained by the current institutional environment of China.Deflationary Expansion, China, Existence and Stability Conditions of Equilibrium, Business Fluctuations, monetary policy, Central Banking, Supply of Money and Credit

Expectations, deflation traps and macroeconomic policy

We examine global economic dynamics under infinite-horizon learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. As in Evans, Guse and Honkapohja, European Economic Review (2008), we find that under normal monetary and fiscal policy the intended steady state is locally but not globally stable. Unstable deflationary paths can arise after large pessimistic shocks to expectations. For large expectation shocks that push interest rates to the zero lower bound, temporary increases in government spending can effectively insulate the economy from deflation traps.adaptive learning; monetary policy; fiscal policy; zero interest rate lower bound