Speech, Bernanke --Deflation-- November 21, 2002

It is nice to see that Bernanke was thinking about our current situation already seven years ago.

Speech, Bernanke --Deflation-- November 21, 2002: Deflation: Its Causes and Effects: Deflation is defined as a general decline in prices, with emphasis on the word 'general.' At any given time, especially in a low-inflation economy like that of our recent experience, prices of some goods and services will be falling. Price declines in a specific sector may occur because productivity is rising and costs are falling more quickly in that sector than elsewhere or because the demand for the output of that sector is weak relative to the demand for other goods and services. Sector-specific price declines, uncomfortable as they may be for producers in that sector, are generally not a problem for the economy as a whole and do not constitute deflation. 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.¹ Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress.
However, a deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero.² Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound."
Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be.³ To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.
Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value. When William Jennings Bryan made his famous "cross of gold" speech in his 1896 presidential campaign, he was speaking on behalf of heavily mortgaged farmers whose debt burdens were growing ever larger in real terms, the result of a sustained deflation that followed America's post-Civil-War return to the gold standard.⁴ The financial distress of debtors can, in turn, increase the fragility of the nation's financial system--for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. Japan in recent years has certainly faced the problem of "debt-deflation"--the deflation-induced, ever-increasing real value of debts. Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year.
Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern--the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.⁵
Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. The central bank's inability to use its traditional methods may complicate the policymaking process and introduce uncertainty in the size and timing of the economy's response to policy actions. Hence I agree that the situation is one to be avoided if possible.
However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero. In the remainder of my talk, I will first discuss measures for preventing deflation--the preferable option if feasible. I will then turn to policy measures that the Fed and other government authorities can take if prevention efforts fail and deflation appears to be gaining a foothold in the economy.
Preventing Deflation
As I have already emphasized, deflation is generally the result of low and falling aggregate demand. 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.⁶ Most central banks seem to understand the need for a buffer zone. For example, central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year. Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero. Of course, this benefit of having a buffer zone for inflation must be weighed against the costs associated with allowing a higher inflation rate in normal times.
Second, the Fed should take most seriously--as of course it does--its responsibility to ensure financial stability in the economy. Irving Fisher (1933) was perhaps the first economist to emphasize the potential connections between violent financial crises, which lead to "fire sales" of assets and falling asset prices, with general declines in aggregate demand and the price level. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks.
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 (Orphanides and Wieland, 2000; Reifschneider and Williams, 2000; Ahearne et al., 2002). By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails.
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? 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 deflation arise. Furthermore, the specific responses the Fed would undertake would presumably depend on a number of factors, including its assessment of the whole range of risks to the economy and any complementary policies being undertaken by other parts of the U.S. government.⁷
Curing Deflation
Let me start with some general observations about monetary policy at the zero bound, sweeping under the rug for the moment some technical and operational issues.
As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.
The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).⁸ 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. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
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.⁹ There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

Deflation for dummies

News N Economics:

Deflation is a a nominal phenomenon and is determined by the quantity of money available in the economy relative to the demand for money. Deflation will result if:

• Strong productivity growth is not matched by a likewise increase in the money supply.
• Declining money supply due to restrictive monetary policy or a collapsing money multiplier.

Keynesian models allow for real shocks to the economy to affect price levels via aggregate demand. In this case, a crash in the housing market that affects aggregate consumption could cause price levels to decline as long as the Fed does not respond by cutting its nominal target to stimulate the macro-economy. Whatever the cause, deflation is a U.S. anomaly.

The chart lists annual inflation in the U.S. spanning back to the Great Depression. This 43-month recession saw deflation up to -10.74% and a severe contraction in economic activity; the average annual growth rate spanning 1930-1933 was -9.3%.
This is a perfect example to illustrate how deflation can be a serious problem. Driven by severely restrictive monetary policy (the central bank was not increasing the monetary base quickly enough), saving was wiped out and the availability of goods and services fell substantially.

The classic economic costs of deflation are:

• With debt obligations being set in advance and deflation occurring unexpectedly – think of a fixed mortgage rate –all nominal variables fall (labor income), except for those tied to preset debt obligations. The resulting economic impact is a transfer of wealth from the debtor to the creditor. The deflation gives easy money to those who made the fixed loans, and causes difficulty in making payments for those who took out the loans. Debtor spending falls (must consume less to make the mortgage payments) and saving falls, but this is unlikely matched by an increase in spending and saving on the part of the creditors. The aggregate effect can be disastrous: spending contracts, saving is wiped out and default rates skyrocket.
• Production and consumption decisions based on price expectations change. Consumers and firms do not know what to expect going forward, resulting in less demand and less production. If deflation becomes embedded in consumer expectations, consumers spending falls and economic growth suffers further.

Deflation is not an axiom of recessions. Prices fell during the 2001 recession and afterward because of the weak labor market. The rising unemployment rate put downward pressure on wages that dragged down price pressures, resulting in sharp disinflation (deflation on a monthly basis). Furthermore, prices fell in the 1981-1982 recession because Paul Volcker restricted the money supply with the exact intent of driving down inflation. However, during the 1980 recession, inflation hit 14.73% during the quarter that saw a -7.8% contraction.

Some say that the Fed is pushing on a piece of string: flooding the banking system with massive amounts of liquidity and seeing no stark improvement in the macro-economy. However, what the Fed is doing is maintaining positive money supply growth positive. As long as Bernanke keeps the liquidity hose on and the money multiplier doesn’t fall to zero, the money supply will not contract.
The money supply is growing and sharply reducing the probability that deflation – especially levels seen in the Great Depression – disrupts the macro-economy.

To be sure, the Fed is worried about deflationary pressures, as illustrated by its shift toward quantitative easing. However, the Fed is doing its job by keeping the money supply afloat. It’s Congress’ turn to step up with its $500 billion stimulus package to rescue the macro-economy.
Rebecca Wilder

Is the US at imminent risk of inflation?

Alan Metzler says the US is in imminent risk of inflation:

Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation.

Paul Krugman posts this graph of Japan's 'lost decade' as a counter example:

Krugman explains why budget deficits will not currently cause inflation here.

Perhaps they are both right, but Krugman is worried about the short run (2-5yrs) outlook and Metzler is worried about the long-run outlook (5-10yrs).

Here is a synthesis view:

Deflation raises questions about global recovery, by Martin Feldstein, Project Syndicate: The rate of inflation is now close to zero in the US and several other major countries. The Economist recently reported that economists it had surveyed predict that consumer prices in the US and Japan will actually fall this year as a whole, while inflation in the euro zone will be only 0.6 percent. South Korea, Taiwan and Thailand will also see declines in consumer price levels. ...
Deflation is potentially a very serious problem, because falling prices — and the expectation that prices will continue to fall — would make the current economic downturn worse in three distinct ways.

The most direct adverse impact of deflation is to increase the real value of debt. ... [T]he price level could conceivably fall by a cumulative 10 percent over the next few years. If that happens, a homeowner with a mortgage would see the real value of his debt rise by 10 percent. Since price declines would bring with them wage declines, the ratio of monthly mortgage payments to wage income would rise.

In addition..., deflation would mean higher loan-to-value ratios for homeowners, leading to increased mortgage defaults... A lower price level would also increase the real value of business debt, weakening balance sheets and thus making it harder for companies to get additional credit.

The second adverse effect of deflation is to raise the real interest rate... Because ... central banks have driven their short-term interest rates close to zero, they cannot lower rates further in order to prevent deflation from raising the real rate of interest. Higher real interest rates discourage credit-financed purchases by households and businesses. This weakens overall demand, leading to steeper declines in prices.

The resulting unusual economic environment of falling prices and wages can also have a damaging psychological impact on households and businesses. ... If prices fall at a rate of 1 percent, could they fall at a rate of 10 percent? ... Such worries undermine confidence and make it harder to boost economic activity.

Some economists have said that the best way to deal with deflation is for the central bank to flood the economy with money in order to persuade the public that inflation will rise in the future... In fact, the Federal Reserve, the Bank of England, and the Bank of Japan are doing just that under the name of “quantitative easing.”

Not surprisingly, central bankers who are committed to a formal or informal inflation target of about 2 percent per year are unwilling to abandon their mandates openly and to assert that they are pursuing a high rate of inflation. Nevertheless, their expansionary actions have helped to raise long-term inflation expectations toward the target levels. ...

Ironically, although central banks are now focused on the problem of deflation, the more serious risk for the longer term is that inflation will rise rapidly as their economies recover and banks use the large volumes of recently accumulated reserves to create loans that expand spending and demand.

Deflation In A Nutshell

I have never seen a textbook that gave a good analysis of deflation, so I put together my own. It really isn't that complicated.
Deflation is negative inflation. It is a decline in the average price level which is the same thing as an increase in the real value of money. We have had very large deflation in computer hardware prices for the past half century, but this is not what people usually mean when they talk about deflation because most nominal prices have still been going up.  Deflation comes from two sources:

• Increased money demand due to increased productivity which lowers the real price of goods and increases output and incomes.  This kind of deflation was relatively common under the gold standard because the money supply could not grow to accommodate economic growth. Under fiat money, deflation is rare because central banks expand the money supply to keep up with economic growth.
  
• Declining money supply due to a drop in the monetary base or a drop in the money multiplier (the willingness to make loans).  This is worse than the other cause because it is usually caused by some kind of economic crisis and it further decreases aggregate demand and exacerbates recession.
  

What causes increasing declining money supply and/or increasing money demand?

• Declining money supply is caused by central bank policy and/or individual banks becoming less willing to lend out money. In 2008 banks became insolvent and many ceased lending money which tends to contract the money supply. This was also a problem during the Great Depression when banks not only became insolvent, but many went bankrupt and even healthy banks were reluctant to loan out money because they were afraid of ‘bank runs’ by their depositors.
• Once central banks lower their interest rates to zero, they have no more ability to increase money supply using this conventional tool.
• Instead they can do “quantitative easing” and “unconventional monetary policy” which is more experimental. The central bank increases the money supply by buying up securities from banks, giving them new money to lend. These securities could be government bonds, commercial loans, asset backed securities, or even stocks.
  
• Alternatively, they could actually print more cash to increase the money supply, but they are loathe to do that for fear of losing investor confidence and future inflation. The US government borrows vast amounts of money each year and if they began printing money, they might have a hard time continuing to borrow money. I’m not sure these fears are rational. Nobody has ever tried it to combat deflation. Usually printing money is caused by governments that cannot raise taxes nor borrow money and printing money is the only way that they can pay for stuff. Printing money is associated with economic collapse because it is often caused by economic collapse and in normal times it causes hyperinflation, but a deflationary spiral is NOT normal times. This is a risky option for combating deflation simply because nobody has tried it and so the empirical result is completely unknown.
  
• Increasing money demand is caused by
• Expectations of deflation. If you expect 5% deflation, that means that cash gives you a real return (risk free) of 5%/year! Cash becomes a good investment whereas during inflation it is not an investment, but something that is costly to hold and is mainly used for transactions rather than as a store of wealth.
• Deflation of other assets in investor portfolios means that the prices of stocks, bonds, and land are going down. If you think your other investments are going down in value, then you would be better off to sell them and hold more cash.
  
• Expectation of higher risk in other portfolio options. If the stock market and bond market experience higher volatility and greater chances of default, then money becomes less risky in comparison.
• If you think that you might loose your job, then your appetite for risk goes down and you would be more likely to transfer some of your portfolio out of more risky assets like stocks and long-term bonds towards more liquid assets like cash.
  
• Both of these factors (increasing money demand and decreasing money supply) tend to happen at the same time during a general deflation.
  

Problems caused by deflation:

• It raises the real interest rate = the nominal market rate minus inflation. (Thus if prices fall 5 percent per year and the nominal interest rate is a modest 3 percent, the real interest rate is actually a high 8 percent.)
• Real interest rates (r) must be larger than the negative deflation rate because the opportunity cost of lending money is to just keep it buried in a vault and it increases in value risk free.  Also r = i - inflation and because nominal interest rates (i) are always positive, the real interest rate (r) must be bigger than the negative inflation rate.  A big deflation then forces big real interest rates which hurts investment.
  
• Nominal interest rates cannot be negative. Nobody is going to pay you to borrow their money. Ever.
• Deflation rewards creditors and those with cash at the expense of debtors and those with illiquid assets.
• Can increase foreclosure problems. Incomes decline, but real loan payments do not decline (or not as much as incomes decline). This increases lending costs and also pushes up real interest rates.
  
• Deflation increases the incentive to save and decreases the incentive to borrow which decreases aggregate demand.
  
• It increases the real value of debt which increases loan defaults because nominal wages (and incomes) decline, but nominal loan payments are fixed. Higher defaults and foreclosures further reduce bank lending which reduces the money supply (see above).
  
• Decreases aggregate demand due to expectations of lower future prices.
• ↓C: consumers will tend to delay discretionary purchases if they anticipate that prices will drop.
  
• ↓I: Businesses that are able to expand will tend to choose not to expand if they anticipate that prices will drop.