Who's Afraid of Deflation?

Concerns about deflation - the phenomenon of falling prices of goods and services - in the wake of the financial crisis, have provided the intellectual cornerstone for central banks around the world - led by the Federal Reserve - to embrace unconventional policy measures, notably forward guidance and large scale asset purchases or quantitative easing.

The deflation aversion has greatly influenced policymakers in the United States, thanks to the legacy of the Great Depression and the fact that the former Governor of the Federal Reserve, Ben Bernanke, remains a leading authority on this episode.  Most economic historians attribute the depth and long duration of the Great Depression to excessively tight monetary policy pursued by the newly formed Federal Reserve at the time.  More recently, central bankers have also been keen to avoid the decade long deflation that has afflicted Japan.

The Bank of International Settlements has recently examined the historical record of deflation and output growth (The costs of deflation: A historical perspective).  The analysis is based on a newly developed dataset of 38 economies covering 140 years.  Their key findings are as follows.

1. There is only a very weak link between deflation of goods and services and growth in output.  On face value, the finding suggests that deflation is not particularly costly.

2. There is a stronger link between asset price deflations - particularly falling property prices - and output growth.

3. The modern day pre-occupation with deflation stems from the Great Depression, where deflation was associated with significant output losses.

4. Japan's deflation in recent decades might reflect the rapid ageing of the country's population.  When controlling for the demographics of ageing, Japan's economic performance has been comparable to the United States since the turn of the century. 

5. The BIS study concludes that policy makers should not necessarily be afraid of deflation in goods and services, but should be vigilant in monitoring and responding to asset price deflation, particularly persistent declines in property prices.

Based on a simple demand-supply framework, it is self-evident that not all deflationary episodes are pernicious.  Falling prices of goods and services can reflect a demand shock, a supply shock or a combination of the two.  The diagram below show that bad deflation is associated with lower demand (ie. lower prices and output), while good deflation is associated with a positive supply shock (ie. lower prices and higher output).  Bad deflation is contractionary while good deflation is expansionary.  This framework downplays the causal role of deflation; rather, it interprets deflationary episodes as symptomatic of unexpected shifts in demand and supply.

A positive supply side shock might reflects factors which lift a country's productivity growth or supply of inputs, such as innovation, technological change and permanent tax cuts which induce greater workforce participation.  The results of the BIS study - that goods and services deflation does not appear to be costly on average over the sweep of the past 140 years - suggests that positive supply side shocks have played an important role in underpinning deflationary episodes in the past. 

With the exception of Japan, few countries have experienced persistent deflation in recent decades.  But many countries have undergone a period of disinflation in goods and services - a moderation in the rate of price growth - since the financial crisis.  During this time, prices of goods and services in advanced economies have expanded at a compound annual rate of well below 2% compared to growth of 2-3% during the credit boom (see chart). 

The Great Disinflation - A Demand Contraction

The fact that growth in real GDP has also slowed markedly since the financial crisis confirms that a contraction in demand has underpinned the Great Disinflation.  Moreover, house prices remain below their prior peak in the United States and many advanced economies which offers compelling evidence of an adverse and persistent demand shock (see chart).  The finding of the BIS study that property price deflations have historically been associated with significantly weaker output growth probably reflects the fact that lower house prices undermine aggregate demand by reducing wealth and collateral values.  Thus falling house prices combined with deflation or disinflation of goods and services represents a clear signal of an adverse demand shock that central banks should remain vigilant towards.

Contrary to the conclusions of the BIS study, I am sceptical that Japan's rapidly ageing population has caused or contributed to its persistent deflation in recent decades.  It is widely accepted that ageing is associated with a negative demand shock which other things being equal, should be deflationary.  But a smaller working age population is also associated with a contraction in supply, which should be inflationary.  In my view, Japan's deflation stems from a shortfall in aggregate demand related to the tight stance of monetary policy (up until recently) and an unwillingness of successive governments to let zombie banks die.  The more aggressive stimulus adopted by the Bank of Japan under its new Governor is therefore a welcome development.

Revival of animal spirits crucial to the outlook

Central banks have been justified in resorting to unconventional policy measures to address growing deflationary risks associated with the shortfall in aggregate demand since the financial crisis.  The series of synchronised policy easings by many of the world's central banks through January and February should be viewed through this prism.  For too long since the financial crisis, some central bankers and many commentators have under-estimated the power of monetary policy.  Even if the equilibrium global interest rate has declined - as argued by Ben Bernanke in his recent blog post - monetary policy still has an important role to play in boosting the psychology of risk taking in the corporate and household sectors.