Should we be worried about deflation?
| Pages | 169-172 |
Page 169
Against a background of the continuing effects of the sharp declines in recent years in global equity markets, widening output gaps, and weak business and consumer confidence, concerns about deflation in both industrial and emerging market economies have mounted in recent months.With Japan already suffering from deflation and China and several other Asian economies experiencing deflationary pressures, the worry is that these could deepen and even spread more widely. Panelists at a May 29 IMF Economic Forum assessed the risks and debated appropriate policy responses, using a newly released staff report "Deflation: Determinants, Risks, and Policy Options," as a springboard. The panel, moderated by Kenneth Rogoff (IMF Economic Counsellor and Director of the Research Department), comprised Laurence Ball (Professor of Economics, Johns Hopkins University), Manmohan S. Kumar (Advisor, IMF Research Department), Vincent Reinhart (Director of Monetary Affairs, U.S. Federal Reserve System Board of Governors), andPage 170 Kim Schoenholtz (Chief Economist, Citigroup Global Markets). Panelists voiced varying degrees of concern about current risks, but all agreed that the best way to defeat deflation was to prevent it from setting in.
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As Manmohan Kumar, the lead author of the IMF study (see box on page 172 for additional information) noted, deflation can be both costly and difficult to anticipate. It can result from either demand shocks (such as a sharp fall in demand reflecting a severe cyclical downturn, the bursting of an asset price bubble, or excessively tight policies) or supply shocks (arising, for instance, from technological innovation and productivity growth).While temporary deflation may not entail major costs, sustained deflation is seldom benign. It leads to a redistribution of income from debtors to creditors, depressed demand, and, potentially, a severe distortion of credit intermediation as collateral loses value. The biggest concern is that a temporary period of declining prices settles in and becomes a sustained and self-enforcing deflationary spiral. And, since nominal interest rates cannot fall below zero, the effectiveness of monetary policy can be constrained-a particular concern when output is weakening.
The toll that deflation can take is apparent from history. The most extreme case of a deflationary spiral, Kumar indicated, was the worldwide deflation and catastrophic collapse of activity in the late 1920s and early 1930s. But even the milder but sustained deflationary episodes of the nineteenth century were generally associated with rising debt burdens and bankruptcies, social and political unrest, financial crises, and significant output volatility. History also highlights how difficult it is to anticipate deflation.
There were forecasts of inflation in Japan in the mid- to late 1990s, for example, even as deflation was setting in.
Do current conditions warrant concerns about deflation? The IMF's Kenneth Rogoff saw relatively low risks of global deflation but added that there were risks of deflation intensifying in Japan, and considerable risks of mild deflation in Germany. Kumar added that in a number of countries the risk of an onset of deflation is relatively high and has drifted upward over the past several years. Asian economies-Japan in particular, but also Hong Kong SAR and Taiwan Province of...
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