Deflation The new threat?
| Author | Manmohan S. Kumar |
| Position | Advisor in the IMF's Research Department |
| Pages | 16-19 |
Page 16
In recent months, concerns about the risk of global deflation have increased. Market commentators like Stephen Roach have emphasized the vulnerabilities in the global economy, and, in a speech to the Economic Club of New York City in December 2002, Alan Greenspan, Chairman of the Board of Governors of the U.S. Federal Reserve System, noted that it was crucial to "ensure that any latent deflationary pressures are appropriately addressed well before they become a problem." This is the second time in five years that concerns about deflation have surfaced-the first was in 1997 and 1998, in the wake of the Asian financial crisis-marking a radical shift in the post-World War II preoccupation with inflation.
This time, worries have been sparked by Japan's ongoing deflation (see "Country Focus" on page 55), deflation in mainland China and several other Asian emerging markets, and the marked reduction of inflation rates in industrial countries. In the industrial countries, inflation, as measured by the consumer price index (CPI), has declined to an average of less than 2 percent, a level not seen since the 1950s (Chart 1), while inflation rates in emerging market economies are the lowest they have been since the late 1960s.
Low inflation brings substantial benefits, for example, more efficient resource allocation and a reduction in uncertainty. But, under today's economic conditions-weak global activity, increasing excess capacity, and the lingering effects of the bursting of the equity price bubble, combined with ongoing structural changes in the world economy-low inflation (less than 2 percent or so) can increase the risk of deflation.
There are different intensities of deflation. Deflation may be relatively mild, with aggregate price indices declining only by a percent or so, and temporary, lasting not more than a few quarters; or it may be mild but persist for several years; or it may be sustained and virulent, with economic stagnation and high unemployment accompanying falling prices and costs, as during the Great Depression of the 1930s, the most severe deflation of the twentieth century.
The first type, as seen, for instance, in Canada, Norway, and Sweden in the late 1980s, might result from a cyclical deficiency in demand or a demand-side shock-say, a drop in demand following the bursting of an asset price bubble. In this case, deflation is accompanied by a slowdown or even a declinePage 17 in aggregate activity, but the decline in activity and prices is temporary. A considerable number of developing countries have also experienced falling prices in recent years. But these declines, often brought about by severe declines in commodity exporters' terms of trade, have been short-lived or small.
Chart 1
Inflation and deflation
The lowest inflation rates in decades have given rise to concerns about deflation.
[ SEE THE GRAPHIC AT THE ATTACHED PDF ]
A mild and temporary deflation may also result from major supply-side improvements, as seen recently in China, or decreases in import prices. Under such circumstances, economic activity may remain strong and asset prices may even go up.
Nonetheless, in both cases, especially if it is unanticipated, deflation leads to a redistribution of income from debtors to creditors-that is, from groups with a high propensity to spend to those with a low propensity-depressing demand. In the presence of rigid nominal wages and falling prices, it also increases real labor costs and reduces competitiveness. Given the natural floor of zero on nominal interest rates, real interest rates rise as prices decline, curtailing the effectiveness of monetary policy-of particular concern when output is weakening. The financial sector could suffer, with a decline in the creditworthiness of businesses and households as debt obligations increase in real terms.
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