Key points in this Outlook:
- Inflation is falling in the United States, Europe, and China, suggesting a real threat of impending deflation that could cripple the global economy.
- Deflation is especially dangerous because it is self-reinforcing; once it takes hold, economic conditions will get much worse before they get better.
- Central banks in the United States and around the world must end their complacency and respond preemptively to the threat by monitoring inflation rates and undertaking aggressive monetization.
Anyone taking painkillers knows that it is important to ingest the medicine before the pain intensifies. You must be preemptive. If you delay taking that pill until you feel pain, you are in for some real discomfort before you feel relief.
The same is true with deflation. It is necessary to be preemptive. Deflation is self-reinforcing, so if you wait to offset it until prices are actually falling, you risk losing control. The resulting pain can be more substantial than the physical pain that results from delaying ingestion of painkillers, since those will eventually quell discomfort, and deflation’s appearance suggests that it will intensify before you can get control of it.
It is not as if no one is noticing that deflation is creeping closer. The March 29 weekend Financial Times front-page, above-the-fold headline was, “Specter of eurozone deflation in view.” Underscoring that fear, actual eurozone inflation for March was reported at a 0.5 percent year-over-year pace, down from a 0.7 percent pace in February. Core inflation in Europe is falling as well. Figure 1 shows measures of trend inflation since March 2011.
US inflation indices are also falling (figure 2). Personal consumption expenditure (PCE) inflation was down to a year-over-year pace of 0.9 percent in February from 1.2 percent in January. The core PCE (excluding food and energy) inflation indicator was recorded at a 1.1 percent year-over-year rate in February, about half of the Federal Reserve’s 2 percent goal for inflation.
After its March 19 meeting, the Fed published forecasts for inflation. PCE inflation is predicted to run at about 1.5 percent during 2014 and then to rise modestly to the 1.5–2 percent range during 2015. But even those modest goals are slipping out of reach. PCE inflation will have to rise rapidly toward 2 percent from its current level of 0.9 percent to meet the targets suggested by the Fed’s inflation forecast.
One voting member of the Federal Open Market Committee (FOMC) expressed a dovish dissent from the Fed’s March 19 statement, suggesting that the FOMC did not express its commitment to return inflation to the 2 percent target strongly enough. Oddly, other, more-hawkish members of the FOMC have continued to express fears of the return of inflation above the Fed’s target range, not- withstanding the persistent deceleration of the inflation rate appearing in the data.
Disinflation is also intensifying in China, which by 2012 accounted for nearly one-fifth of global growth. As recently as January, most forecasters were calling for a year-over-year inflation rate in 2014 for China of 3 percent. With the release of first-quarter data that showed Chinese growth and inflation below expectations, inflation forecasts for China were dropped to 2 percent, well below the official target of 3.5 percent. Now, in 2014, China’s disinflation is helping to push down global inflation rates.
With the United States, Europe, and China all undershooting expected inflation, and Europe and the US with inflation actually below a 1 percent year-over-year trend pace, deflation is no longer a hypothetical possibility—rather, it is a threat that should be taken seriously.
The threat from deflation is not always obvious to either the general public or, apparently, the many policymakers who continue to dismiss the possibility of outright deflation. For the last several months, the Fed has treated the American drift toward deflation as temporary. In a March press release, the FOMC said, “The committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.”
The Fed’s presumption that inflation will move back toward 2 percent rather than drift lower is perhaps a dangerous one and certainly suggests an asymmetric concern about the pace of price increases at the Fed. With inflation actually having dropped below 1 percent on a trend basis, the Fed should be suggesting, as one dissenting member of the FOMC has, that inflation could drift lower and that it would take aggressive action to offset it. Surely the hawks would jump on a 3 percent inflation rate, as it is dangerously above the 2 percent inflation target.
The harsh reality, of course, is twofold. First, it is not clear what the Fed could do to offset deflation, given that it is abandoning quantitative easing and forward guidance at a time when interest rates are locked at a level close to zero. Second, as the Fed persists in its modest tightening regime, its bias is for inflation to continue to drop rather than to increase. Given that the Fed has suggested that it will be able to withdraw stimulus over the next 18–24 months, it is clear that an assumption that inflation will somehow return to the 2 percent level while the Fed is tightening is embedded in FOMC thinking, evidence to the contrary notwithstanding.
The European Central Bank (ECB) has thus far taken no overt action to slow the pace of disinflation, which is taking year-over-year price changes perilously close to zero. Nor have the Chinese undertaken any extra overt measures given the undershoot of the inflation pace emerging in the Chinese data. China’s weakness is further underscored by persistent weakness in the price of copper, which serves as a proxy for the intensity of overall economic activity in China. After hovering around a price of about $7,200 per ton for about six months, the price of copper fell sharply during March, by about 10 percent, suggesting disinflation in China, a major global consumer of copper.
Deflation Complacency Makes Deflation More Likely
Leading policymakers—including those at the Fed, International Monetary Fund, and ECB—give two reasons for their complacency about deflation. First, they suggest that measures of expected inflation are well-anchored. Second, some argue that when actual inflation is between 0 and 2 percent, inflation expectations are in a quiet zone, not likely to change abruptly. There is little evidence for the latter assertion, while the former notion—well-anchored inflation expectations—is akin to the patient who delays taking the painkiller because he is not currently feeling any pain. Once the pain hits, it is too late to avoid it. Once deflation takes hold, its self-reinforcing nature makes it hard to
Japan’s experience with its drift into deflation during the 1990s can teach the US and Europe some lessons about complacency today. In December 1994, the Organization for Economic Cooperation and Development (OECD) projected that Japan’s 1995 inflation rate would run at 0.6 percent annually. In December 1995, after the actual 1994 inflation rate had been reported at 0.1 percent, the OECD lowered its projection for 1995 inflation to −0.9 percent. Commenting on Japan’s slide into deflation during the 1990s, JPMorgan Chase reports, “What is striking about Japan’s slide into deflation in 1994 is that no one seemed to be expecting it.” Further it observed that at the end of 1994, “when deflation was getting under way, the OECD anticipated positive inflation through the end of the forecast horizon in 1996. Projections of deflation followed the decline in prices rather than anticipating it.”
Today’s actual year-over-year US inflation trend, as measured by the personal consumption deflator the Fed favors, is 0.9 percent. The Consumer Price Index (CPI) year-over-year inflation rate is 1.1 percent. As already noted, the OECD forecast for US CPI inflation in 2014–15 is 1.8–1.9 percent. This optimism about a rapid inflation rebound looks distressingly similar to the OECD’s complacent view on Japanese deflation at the end of 1994, just as Japan slipped into actual deflation. The year-over-year inflation forecast late in 1994 for 1994–96 held at 0.6 percent despite an actual inflation rate of zero. By December 1995, after deflation had actually taken hold, the 1994–96 “forecasts” were changed to 0.1, −0.9, and −0.4 percent. By then, it was too late to reverse deflation.
Japan’s experience in the 1990s reinforces the notion that inflation expectations are sticky in the downward direction. The appearance of actual disinflation does not trigger expectations of deflation until deflation appears. If policymakers are determined to wait until deflation appears before acting to offset it, they run the risk of a self-reinforcing deflation that can do serious damage to the economy. In Japan’s case, the serious damage came to be called its “lost decade,” characterized by slow growth, a persistently falling price level, a tendency toward currency appreciation that reinforced deflation, and an absence of investment.
Why Deflation Is Self-Reinforcing
Deflation is self-reinforcing for two basic reasons. First, when prices start to fall, the desire to hold cash is reinforced. The reason is straightforward: a fall in the price level rewards cash holders with a risk- and tax-free return equal to the rate of deflation. On average, the long-term risk-free return on assets is between 2.5 and 3 percent. So an actual deflation rate of 2.5 percent provides households and firms with a way to earn attractive investment returns while taking no risk and doing nothing with their money other than holding it in idle cash balances. That is a liquidity trap.
We see the self-reinforcing nature of deflation in the fact that nominal or market interest rates cannot go below zero. The “zero bound” means that the real interest rate that determines investment spending and household spending rises as the deflation rate rises. A −3 percent inflation rate means that the real interest rate, or the real cost of money, is 3 percent.
A rising real interest rate discourages investment, and weaker investment results in slower growth, which in turn reinforces the tendency for deflation to accelerate. In fact, many commentators have been surprised by the weakness of US investment spending during this weak recovery (figure 3). Few have observed that falling inflation and the threat of deflation that boosts the real costs of borrowing may be to blame. Beyond pushing up the real cost of borrowing, actual deflation reduces the attractiveness of investments since the goods produced with the investment may be saleable only at a lower price, thereby reducing the return on any investment.
The complacency at central banks about the threat of deflation constitutes a necessary but not sufficient condition for deflation to appear. If the complacency were absent, central banks would take more proactive measures to offset the tendency toward deflation. But such measures run contrary to the current path of the Federal Reserve and the current beliefs of the ECB that somehow inflation will recover back to 2 percent, or thereabouts, on its own with no additional action on its part.
Many underestimate the danger of self-reinforcing deflation—that once it appears, it tends to accelerate. This complacency may be partly due to Japan’s experience in which deflation appeared and persisted but never dropped much below a 1.5 percent pace. That may be because the Bank of Japan (BOJ) provided just enough of a drip feed of expansionary measures to avoid acceleration of deflation. That said, if complacency at central banks in the US, China, and Europe persists and deflation appears on a global basis, the likelihood of a self-reinforcing deflation process that operates globally is higher.
Japan may have been rescued to some extent during its lost decade by the presence of rapid growth in China and most industrial economies, especially prior to the global financial crisis in 2008. Global deflation is a more insidious possibility today given the widespread drift toward falling prices evident in most major economies. While Japan has made a little progress in moving away from outright deflation, it is not clear its efforts in achieving a 2 percent inflation rate would be successful in an environment of global deflation.
The last example of global deflation was, of course, the Great Depression. In that case, prices fell rapidly and at an accelerating pace until the US managed an abrupt reflation through the devaluation of the dollar tied to a doubling of the price of gold. That drastic reflationary measure stemmed the deflation that had emerged by 1933, but even that approach failed to rekindle actual inflation until the onset of World War II.
How to Preempt Deflation
Policymakers need to undertake a global effort to combat the possibility of deflation. That requires a global commitment that includes both measures to prevent deflation from appearing and aggressive monetization as a means to preempt deflation.
Whether central banks, especially the ECB but also the Fed, can overcome their fears that undertaking aggressive global monetization will not cause inflation remains to be seen. The hard part for central banks is reaching the conclusion that preempting deflation requires promising inflation, something that most are loath to do. The BOJ has, however, led the way by undertaking a strategy to end deflation by promising 2 percent inflation and suggesting that it will continue to follow aggressively expansive policies until that goal is achieved. Whether other major central banks can follow the BOJ’s lead before deflation takes hold remains to be seen.
1. Board of Governors of the Federal Reserve System, “Press Release,” March 19, 2014, www.federalreserve.gov/newsevents/press/monetary/20140319a.htm.
2. JPMorgan Chase Bank NA, Global Data Watch, February 14, 2014, 15–16, www.adr.com/Home/LoadPDF?CMSID= 2db076d8f4f04baea9b367296412f649.