The Deflation Bogeyman CAMBRIDGE – The world's major central banks are currently obsessed with the goal of raising their national inflation rates to their common target of about 2% per year. This is true for the United States, where the annual inflation rate was -0.1% over the past 12 months; for the United Kingdom, where the most recent data show 0.3% price growth; and for the eurozone, where consumer prices fell 0.6%. But is this a real problem? The sharp decline in energy prices is the primary reason for the recent drop in the inflation rate. In the US, the core inflation rate (which strips out changes in volatile energy and food prices) was 1.6% over the last 12 months. Moreover, the US Federal Reserve, the Bank of England, and the European Central Bank understand that even if energy prices do not rise in the coming year, a stable price level for oil and other forms of energy will cause the inflation rate to rise. In the US, the inflation rate has also been depressed by the rise in the value of the dollar relative to the euro and other currencies, which has caused import prices to decline. This, too, is a “level effect," implying that the inflation rate will rise once the dollar's exchange rate stops appreciating. But, despite this understanding, the major central banks continue to maintain extremely low interest rates as a way to increase demand and, with it, the rate of inflation. They are doing this by promising to keep short-term rates low; maintaining large portfolios of private and government bonds; and, in Europe and Japan, continuing to engage in large-scale asset purchases. The central bankers justify their concern about low inflation by arguing that a negative demand shock could shift their economies into a period of prolonged deflation, in which the overall price level declines year after year. That would have two adverse effects on aggregate demand and employment. First, the falling price level would raise the real value of the debts that households and firms owe, making them poorer and reducing their willingness to spend. Second, negative inflation means that real interest rates rise, because central banks cannot lower the nominal interest rate below zero. Higher real interest rates, in turn, depress business investment and residential construction. In theory, by depressing aggregate demand, the combination of increased real debt and higher real interest rates could lead to further price declines, leading to even larger negative inflation rates. As a result, the real interest rate would rise further, pushing the economy deeper into a downward spiral of falling prices and declining demand. Fortunately, we have relatively little experience with deflation to test the downward-spiral theory. The most widely cited example of a deflationary economy is Japan. But Japan has experienced a low rate of inflation and some sustained short periods of deflation without ever producing a downward price spiral. Japan's inflation rate fell from nearly 8% in 1980 to zero in 1987. It then stayed above zero until 1995, after which it remained low but above zero until 1999, and then varied between zero and -1.7% until 2012. Moreover, low inflation and periods of deflation did not prevent real incomes from rising in Japan. From 1999 to 2013, real per capita GDP rose at an annual rate of about 1% (which reflected a more modest rise of real GDP and an actual decline in population). Why, then, are so many central bankers so worried about low inflation rates? One possible explanation is that they are concerned about the loss of credibility implied by setting an inflation target of 2% and then failing to come close to it year after year. Another possibility is that the world's major central banks are actually more concerned about real growth and employment, and are using low inflation rates as an excuse to maintain exceptionally generous monetary conditions. And yet a third explanation is that central bankers want to keep interest rates low in order to reduce the budget cost of large government debts. None of this might matter were it not for the fact that extremely low interest rates have fueled increased risk-taking by borrowers and yield-hungry lenders. The result has been a massive mispricing of financial assets. And that has created a growing risk of serious adverse effects on the real economy when monetary policy normalizes and asset prices correct. About the Author Martin Feldstein Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board,… read more
I read this without knowing the author, until the end, and thinking the whole way through, this is correct, by God!! Finally something on ET that is actually correct! So why is Tao posting it? Well, one can only assume that he misread Feldstein as saying deflation is ok, go for it. Because that is what Tao has been maintaining. But of course Feldstein's main point here, correctly saved to the last paragraph, is to point out that there can be a downside of maintaining ultra low rates for long periods: risky assets get bid up in the search for yield, and so do Treasuries. It is a difficult environment for yield seekers. These are good points and raising them is just another way of saying there is no free lunch. (This piece may also be Feldstein's way of saying "here I am, remember me!", and reminding us that he still matters, and he does.) Careful reading will prove that there is nothing here being recommended that is out of step with current Fed policy -- it is just his cautionary note to let us know we are not really getting away with anything. What Feldstein has left out, but what he understands and knows as well as anyone, is that it is not the nominal yield that's important any more than its the nominal price of an asset that matters. (Of course markets turn on nominal price.) Just as the real cost of borrowed money rises with deflation, sophisticated investors know that dollar appreciation is equivalent to an increase in the real yield of an interest bearing, dollar denominated asset! Feldstein writes: "Why, then, are so many central bankers so worried about low inflation rates? One possible explanation is that they are concerned about the loss of credibility implied by setting an inflation target of 2% and then failing to come close to it year after year. Another possibility is that the world's major central banks are actually more concerned about real growth and employment, and are using low inflation rates as an excuse to maintain exceptionally generous monetary conditions. And yet a third explanation is that central bankers want to keep interest rates low in order to reduce the budget cost of large government debts." I think he is right on target here, except for his childish suggestion that Central Bankers haven't done a good job of hitting their two percent target. What they don't want is sustained negative inflation,i.e., deflation, and they've done a masterful job so far of keeping us in safe waters. The two percent target is set to allow room for uncertainties. One point 6 percent inflation is just fine! I might take issue too, with Feldstein's using Japan as an example of what may be expected in the U.S. To be sure, we don't want to have an economy like Japan's has been for a long time. But the best example for the U.S. of what can happen under deflation with unhelpful Central Bank policy is itself in the 1930s! Now if only the U.S. Congress could be half as helpful and as competent as the Fed!
I find that Marty is being somewhat disingenuous, at least in some of the things he has said. So I am not sure I like the article all that much. Since when is real per capita GDP used as the most accurate measure of real income? What happened to all the things like wages and salaries and all that jazz?
I'm just curious, but does referring to me in the third person when I'm right "here" somehow give your ramblings a sense of legitimacy? Is it supposed to read like you're sharing your intimate and private thoughts with the peasantry and that we should all he honored to have such a brief glimpse into that giant egg you call a head and brain? You probably don't realize how (even more) pompous you come off, but those who are stuck in academia with no real world experience are usually social misfits. Big shocker there. Both Congress and the Fed haven't figured out that there's no free lunch. Both Congress and the Fed are equally opaque in their operations. In fact, the only notable difference is that Congress has elected officials and the Fed's are appointed, but both are equally lobbied and politically owned.
I agree, he is off base there. I thought his tone was a bit nasty when he writes: "Another possibility is that the world's major central banks are actually more concerned about real growth and employment, and are using low inflation rates as an excuse to maintain exceptionally generous monetary conditions." It's as if he is trying to suggest that it is not a good idea to use low inflation as an opportunity to "maintain exceptionally generous monetary conditions" in an effort to bring us out of the exceptionally long lasting hangover from the "great recession". Under the circumstances, what on earth can be wrong with trying to spur growth and employment, considering that "full" employment, rightly or wrongly, is one of the Fed's mandates? What a great opportunity low inflation along with a rising dollar presents! Why not use it to maximum advantage??? (Sadly, our Congress is not doing their part to help the Fed.) Feldstein uses the plural, "central bankers", but it is obvious which central bank he has mostly in mind. The other central banks, having seen that QE works and does not have to lead to massive devaluation of the currency, as so many predicted, are following the trail blazed by the U.S. Fed.
"third person" ? I have no problem with your opinions differing from mine, particularly when you back them up with an argument based on fact. I can learn from that. However when you post statements, other than opinion, that are prima facie wrong, and later prove to be so, or resort to ad hominem remarks, in my eyes it undermines your credibility. I realize this is not something you would necessarily care about. When I post something, other than something posted in jest, I want it to be factually correct. I sometimes fail in that regard. I try to correct substantive mistakes when I discover them, because I do care about my own credibility in others' eyes, including yours.
Yes. Third person. When there is a conversation going on and you refer to an individual who is in the conversation as if they weren't there. That kind of third person. As for being "wrong", you selectively answer questions you want, ignore those that are too difficult. You claim to have full knowledge on a subject - like interest rates, yet have never heard of prominent names in the field like Jim Grant. You make nauseatingly blatant cheerleading comments about the Federal Reserve which you do to invoke a response, which, when you get, you cry foul and then accuse ad hom attacks of the person who responded. Neither of us has credibility in the other's eyes. The difference is that I don't expect or care to - I've met your type over and over again. There's no converting the brainwashed. Those in the cult never leave.
It's hard to devalue when everyone is doing it. I'm not sure I understand how you can say that the Bank of Japan's program did not lead to a significant Yen depreciation, or that the Euro isn't undergoing significant depreciation, or that the dollar isn't recovering from it's QE driven depreciation now, etc. And saying QE works. What were it's successes again? Are more folks employed? How about in Japan, is inflation now well above 2% and flying? Have wages risen much? At all? How about in the US? Wage growth going well? How can QE directly affect unemployment? Can you please detail how this works? Why is the Fed the only central bank with employment a mandate? Any of these for starters. Take your pick, piezoe.