Deflation Prevention and Cure

Willem Buiter
Chief Economist
19 May 2003

Introduction

Its baaaaack! Definition: sustained decline in cost of living; persistent negative inflation of price index for current goods and services. Practical examples: RPI, RPIX, RPIY, CPI, HICP, GDP deflator, private consumption deflator in the GDP index. Asset price deflation; important, but not deflation as used in this lecture.

Why worry about deflation?

(Alleged) historical association of deflation with financial crises, recession, stagnation and depression. Debt deflation and the Great Depression. (Short) nominal interest rates at zero (zero lower bound problem); liquidity trap monetary policy cannot stimulate demand. But: Bailey & Friedmans optimal monetary rule: zero nominal interest rate. If real interest rate positive, deflation is optimal.

Why the concern today? A little history

Japan: BoJ discount rate at 50bps or less since 1995; now near zero; slump since 1992, GPD deflator has fallen in each of past 5 years; CPI and money wages have fallen in 4 out of past 5 years.

Japan

10

12

14

16

18

20

10

15

20

25

30

-5

(%)

(%)

Short-term Interest Rate

Real GDP Growth (%)

Sources: UN Common Database and Bloomberg.

Sources: UN Common Database and European Commission.
Long-term Interest Rate

CPI Inflation (%)

1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Money Wage Growth (%)

Equity Index (TOPIX, deflated by CPI, 1950=100, Second Axis)

(1950 = 100)

500

1,000

1,500

2,000

2,500

3,000

3,500

1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

 European Union: ECBs repo rate at 2.5%; HICP inflation for 2002 2.2%; real economy faltering; euro strongest since introduction 4 years ago.

10

12

14

16

18

20

10

15

20

25

30

(%)

-5

(%)

European Union

Sources: IMF and European Commission.

Short-term Interest Rate

Real GDP Growth (%)

Long-term Interest Rate

Sources: UN Common Database, Bundes Bank and Bloomberg.

CPI Inflation (%) Money Wage Growth (%)

1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Equity Index (DAX, deflated by CPI, 1976=100, Second Axis)

(1959 = 100)

1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

50

100

150

200

250

300

350

400

450

500

 USA: Federal Funds rate at 1.25%; real economy soggy (Snow). CPI inflation 1.9% for 2002, PCE (personal consumption expenditures deflator) inflation1.9%.

USA

10

12

14

16

18

20

10

15

20

25

30

(%)

-5

(%) Sources: UN Common Database and European Commission.

Short-term Interest Rate

Real GDP Growth (%)

Long-term Interest Rate

Sources: UN Common Database, Federal Funds and Bloomberg.

CPI Inflation (%) Money Wage Growth (%)

1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Equity Index (S&P 500, deflated by CPI, 1950=100, Second Axis)

(1950 = 100)

50

100

150

200

250

300

350

400

450

500

1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

 UK: Bank of Englands repo rate at 3.75%; For 2002: HICP inflation at 1.6%; GDP deflator at 3.2%; RPIX at 2.2%; Dec. 2002 at 1.9%, January 2003 at 2.6%, March 2003 at 3.0% (RPI at 3.1%); Sterling weakening; Real economy sluggish.

UK

10

12

14

16

18

20

10

15

20

25

30

(%)

-5

Short-term Interest Rate

Real GDP Growth (%)

Long-term Interest Rate Equity Index (FTSE, deflated by RPI, 1976=100, Second Axis)

(%) Sources: UN Common Database, Wolfbane Cybernetic and European Commission.

Sources: UN Common Database, Bank of England and Bloomberg.

RPI Inflation (%) Money Wage Growth (%)

1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

(1984 = 100)

50

100

150

200

250

300

350

400

1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

UK 1800-1914: inflation highly volatile; average inflation rate negative

20 15 10 5 0 -5 -10 -15 -20 -25
1800 18061812 1818 18241830 18361842 1848 18541860 1866 18721878 18841890 1896 19021908 1914

RPI

RPI (annual % change)

Bank rate never below 2%.

Per cent US dollar

15
Inflation (1hs) Bank rate (1hs)

11 10 9 8 7
/$ exchange rate (rhs)

10 5 0 -5 -10 -15 -20

1817 1827 1837 1847 1857 1867 1877 1887 1897 1907

6 5 4

Good Deflation and Bad Deflation (Bordo and Redish [2003])?

Good deflations: positive supply shocks cause potential real output to grow faster than nominal aggregate demand. Characterised by rising employment and output growth, high profits and booming stock markets. E.g. mild deflation during 1870 - 1896 accompanied by positive growth in many countries. However, growth accelerated during period of inflation after 1896. Bad deflations: negative shocks to aggregate demand cause nominal demand growth to fall below the growth rate of potential real output. Characterised by falling employment and output growth, low profits and falling stock markets (1919-1921, 1929-1933, Japan 1995 -).

Is deflation just inflation with the sign reversed? Are anti-deflationary policies just anti-inflationary policies with the sign reversed?
Symmetries:
1. 2.

Menu costs Shoe-leather costs: anticipated inflation (deflation) raises (reduces) opportunity cost of holding money if nominal interest rate adjusts onefor-one with expected inflation.

Asymmetries:
1. 2.

Zero lower bound on risk-free nominal interest rates Unanticipated inflation redistributes from (non-index linked) creditors to debtors. Unanticipated deflation redistributes from (non-index linked) debtors to creditors. No counterpart in inflation case to default, bankruptcy and painful financial restructuring often found in the deflation case (debt deflation). Asymmetries in upward & downward nominal wage and price adjustment Unfamiliarity (outside Japan) with deflation in living memory.

3. 4.

Why dont we see negative nominal interest rates?

Opportunity cost of holding base money:

i-iM

short nominal interest on non-monetary security

iM nominal interest rate on base money

Bearer securities vs. registered securities
Monetary base:
bank reserves are registered securities

Currency is a bearer security

A carry tax on currency: Gesells Proposal.

Do asymmetric downward nominal price and wage rigidities make deflation particularly costly?

No nominal rigidities (either up or down) in asset markets. In UK, with persistence of low inflation during past decade, price cuts for goods becoming common: UK, 2002 year to August, CPI inflation at 1.9%; CPI goods inflation at -1.1%; CPI services inflation at 4.6% (King [2002]).

Wages: Nickell and Quintini [2003] using micro-data find evidence of statistically significant but small nominal rigidities (spike at zero in density function of money wage contract changes at zero). Note: no evidence for or against asymmetry.
In inflationary world, resistance to a nominal wage cut is a necessary part of resistance to real wage cut. Fairness concerns relative real wages.

Can we disentangle monetary and fiscal policy? Should we care?

4 potential monetary instruments

Conventional

Short nominal interest rate on non-monetary securities

Stock of base money

Nominal spot exchange rate

Note: of 3 conventional monetary instruments, only one can be independently selected by monetary authority under unrestricted international financial capital mobility.

Unconventional

Nominal interest rate on base money

Monetary Policy: any change in one or more of the 4 monetary policy instruments that, at given prices and activity levels, leaves unchanged financial net worth of state, now or in future (state = consolidated general government & central bank).
Fiscal policy: any change in public spending or tax rules, whether or not they alter, at given prices and activity levels, financial net worth of state, now or in future.

How to avoid deflation or how to escape from deflation once youre landed in it. Amounts to question: how can monetary and fiscal policy boost aggregate demand.
Pedantic precision: how can monetary and fiscal policy boost aggregate demand at given (current and future expected) prices & wages, given current and future nominal exchange rates, given current and future expected employment and output levels.

(1)

DH = CH + IH + GH + X

DH : Aggregate demand for domestic output CH : Private consumption demand for domestic output IH : Private investment demand for domestic output

GH : Government spending on domestic output

X: Export demand

Share of private consumption of domestic output in total private consumption depends on the relative price of imports and domestic goods
Same for private investment spending on domestic output and government spending on domestic output.

Total private consumption is the sum of consumption by Keynesian consumers who spend their current disposable income and consumption by permanent income consumers, who smooth consumption over the life-cycle.

Aggregate consumption, C, is sum of the consumption of the permanent income consumers and the Keynesian consumers. Share of consumers is Keynesian. The wage bill is W and labour income taxes is T. (2) C=[A+(1- )H]+ (W-T)

Consumption by permanent income consumers is product of marginal propensity to spend out of comprehensive wealth, , and comprehensive wealth, sum of financial wealth, A, and its share 1- , of human wealth, H.

Financial wealth, A, includes stock market wealth, present discounted value of future profits.
Human wealth, H, is present discounted value of current and future after-tax labour income. Private investment also depends on present discounted value of future profits (Tobins q)

Monetary Policy

Until further notice, assume interest rate on base money (currency) is zero.

(1) Cut in current short nominal interest rate (consider effect on demand at constant exchange rate).
1. 2. Effect on investment through Tobins q. Other mechanisms: credit channel; bank lending channel. Effect on consumption through
1. 2. 3.

Substitution effect Income effect Valuation effect.

Substitution and income effects work through . Valuation effect works through A (stock market) and through H. Significant effect on unlikely (could be negative!). Any positive effect likely to be small ( is small).

(2) Credible announcements of future cuts in nominal interest rates (can be associated with (1)).

(3) Devaluation (consider effect on demand at given current and future nominal interest rates). MarshallLerner conditions; expansionary effect strengthened if country is net foreign currency creditor.

(4) Unconventional monetary policy when short nominal interest rates are zero.

(a) Generalised open market operations

Purchases of any government securities with positive nominal interest rate Sterilised foreign exchange purchases Purchases of other foreign currency assets Purchases of private domestic securities or real assets (stocks, bonds, options, other derivatives, property).

Easing of eligibility requirements for securities acceptable as collateral in repo operations. Expand list of eligible couterparties.

Problems: moral hazard, adverse selection, governance.

(b) Spitting in the wind: introducing an inflation target or raising an existing one when youre flat on the floor.

(c) Negative nominal interest rates through a carry tax on currency.

Fiscal policies to stimulate aggregate demand

(1) Debt-financed (lump-sum) tax cuts

(A) With Keynesian consumers

(B) With permanent income consumers only
(a) Without Ricardian equivalence (debt neutrality) (b) With Ricardian equivalence

(2) Temporary increase in public spending on domestic output, financed any which way.

 (3) The fail-safe policy: Friedmans helicopter drop of money. Equivalent to tax cut (or increase in government transfer payments) financed by printing base money. (4) Feldsteins proposal: use current indirect tax cuts and future indirect tax increases to tilt intertemporal terms of trade in favour of current consumption. Similar to temporary investment tax credit or temporary investment subsidy.

Tackling deflation: how much can the central bank do on its own?

Open market operations. May need help from Treasury to do the unconventional stuff.
Can Central Bank perform helicopter drop of money on its own? Central Bank is not fiscal agent. Requires Treasury assistance (tax cut or transfer payment financed through Treasury borrowing, either directly from Central Bank or indirectly, with Treasury borrowing in market and Central Bank buying Treasury debt in market.

Conclusion

There is no excuse for persistent unwanted deflation. Deflation can be avoided. If it has taken hold, deflation can be eradicated.

Ending unwanted deflation is technically trivial and politically attractive: tax cuts and/or spending increases.

Inflation is always and everywhere a monetary phenomenon (Friedman)

and the price of bananas is always and everywhere a banana phenomenon (Mrs. Mildred Smith from Tooting Bec) Money is always and everywhere a fiscal phenomenon (Sargent and Wallace). Excessive, inflationary budget deficits are the reflection of unresolved social conflict (Joachim Marx).

Final Reflections

Unwanted, persistent deflation is always and everywhere evidence of unnecessary, avoidable macroeconomic mismanagement (including failure to coordinate monetary and fiscal policy). It is not believable that governments have forgotten easy mechanics & attractive politics of boosting inflation/eliminating unwanted deflation.