Tuesday, November 15, 2011

Fed Study: Inflation? What about Deflation?

What Should a Central Bank do in the Following Situation?
A real estate bubble causes Foreign Portfolio Investment to flow into the country. Suddenly, the bubble bursts and the country's financial system collapses. The left blames lax financial standards, while the right blames an inflated money supply.  With all this in mind, the key question is….    What to do With Interest Rates and With the Money Supply?

Japan: Once Upon a Crisis
In early 1990, the Japanese asset price bubble (lit. baburu keiki) came to an end. During this period, Japan renounced currency price intervention and the subsequent bubble attracted foreign speculative funds on a massive scale, in proportion to Japan’s role as the world’s second largest economy (at that time). At the end of the bubble, asset prices and then economic growth declined dramatically. While the Bank of Japan did engage in monetary loosening, the consensus view in retrospect was that the BOJ’s monetary response was wholly insufficient. Stated otherwise, the response of the BOJ to the Japanese asset price bubble was too little, too late.

The BOJ’s policy response came slowly. In March of 1991, a year after the bubble burst, the BOJ’s policy rate was still at its high of 8.2%. This was gradually brought down to 2% in 1995. In 1993-94, there was a brief thaw in the Japanese crisis. This thaw served to dissuade the BOJ against further stimulatory action.

After asset prices collapsed in Japan and firms’ balance sheets deteriorated, interest in lending and borrowing from both the lender side and the borrower side had radically diminished. This in turn eroded the possible effectiveness of monetary action by the BOJ. In this respect, the BOJ missed the crucial opportunity to turn things around – for an entire year–.

This was exacerbated by a “wait and see” attitude adopted by the Ministry of Finance with regard to bank intervention, which persisted until 1997 when Japan’s government used fiscal policy to recapitalize the banks –seven years after the crisis began– . By 1995, Consumer Price Inflation was negative, despite the fact that interest rates were essentially at zero.

Unfortunately, deflation is a much more difficult phenomenon for central banks to remedy. Deflation strongly discourages both investment and consumption. After all, why would, one buy something today when it will cost less tomorrow? For that matter, why would one dare to invest in assets which will only have lesser monetary value next year? Furthermore, how can the central bank react to deflation? Given that deflation occurs during a recession, it certainly can’t solve anything by raising interest rates. In the other direction, interest rates can only be lowered as far as the Zero-lower -bound.

What it Means for us Today
The key lesson about Japan’s crisis, recession, liquidity trap, and deflation, is that if a central bank and an economy are to overcome large economic shocks, the reaction must be swift and it must be decisive. The consequences of hesitating during a crisis amount to exacerbating the crisis and triggering deflation, which is difficult to emerge from.

The Politicians Keep Getting it Wrong
One thing which has clearly emerged in the discourse in the US is conservative anger about the monetary expansionism of the Federal Reserve. On one hand, Herman Cain has proposed switching altering the Federal Reserve’s mandate from two goals – inflation stability and economic growth – to a mandate with the sole aim of inflation stability. On the other, ex-cargo pilot-turned Texas politician Rick Perry calls Ben Bernanke a traitor, ostensibly for not sinking in the US economy in the Japanese fashion.

The Federal Reserve Study
In 2002, the Federal Reserve published a study on the causes, effects, and consequences of the Japanese recession. The study comes to the conclusion that, considering the risks of liquidity trap, deflation, and the difficulty of emerging from the situation, both monetary and fiscal stimulus during a crisis situation should go far beyond conventionally established norms.
About the Author:
The Federal Reserve is the Central Bank of the Unites States of America. 


  1. I never quite understood why governments are so obsessed with inflation. They treat it as public enemy number one when in reality history shows over and over again that moderate inflation is not that bad at all.

    For example, during the 60s and 70s, Brazil inflation rate was 42% a year. Despite this, Brazil was one of the fastest growing economies in the world, with a 9.5% increase per year in per capita income during that period!

    In contrast, between 1996 and 2005, Brazil embranced more neo-liberal polices that indeed reduced inflation to an average of 7.1%, but average per capita income was only 1.3% a year.

    There are many other cases like this and they've been already studied by numerous scholars.

    Therefore it is pretty clear that inflation is compatible with economic growth. Obviously hyperinflation is something to worry about, like Argentina and Zimbabwe know, but arguing that the lower the inflation rate, the better, is, at best, a half truth and, at worst, an outright lie.

    There are many reasons why governments try to keep inflation low (protect pensions and people living on fixed incomes come to mind), but one of the most important ones for me is that central banks listen very closely to their financial sectors and these are inherently against inflation because it can erode their income and disrupt their forecasts.

    This policy bias partially explains the obsession with inflation.

    As you argue in your thoughtful article, politicians and central bankers would be well advised to look at deflation and other economic threats more closely.

    As for Herman Cain and Rick Perry,... well, who takes them seriously anyway?


  2. Well Aurelio,

    I would say that controlling inflation is one of the few positive things that neoliberal economic doctrine has proven to be effective at achieving (sometimes at huge social cost). This point stand out particularly during crisis periods such as the one we are in. They can't improve employment, growth, wealth distribution, or sectoral diversification during a crisis period, but they can prevent inflation (by torpedoing economic growth of course)