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Deflation
August 26, 2010
Q&A on causes, remedies and market implications
In the past two years, inflation in both the US and the eurozone (not taking into account energy-related
fluctuations) has been on a downward trend. Core inflation in both economies has eased to multidecade lows of about 1%. This is getting dangerously close to zero. In combination with the continuing
concerns about the economic outlook this has raised concerns about deflation. With bond yields for
the core markets diving to astonishing lows bond markets are clearly taking the risk of outright
deflation seriously.
Bond markets looking at ultra-low yields
(interest rate on 10-year bonds)
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Jan-57 Jan-62 Jan-67 Jan-72 Jan-77 Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 Jan-07
US
Germany
Japan
Q. What is deflation?
A. A fall in the general price level, but harmful deflation is about more than that
Technically, deflation is defined as a decline in the general price level. However, not all forms of
deflation are created equal. As illustrated in 2009, total inflation can be pushed below zero because of
large fluctuations in commodity prices. The yoyo-move in oil prices through 2008 (up to 145 USD per
barrel by mid-year, back down to 35 USD by year-end) pushed headline inflation below zero for most
of 2009. But moves like this are usually just a temporary effect and not really relevant. Sharp
increases in productivity can also lead to a decline in prices, but this would be accompanied by strong
activity growth.
Harmful deflation, the one that was seen in the 30s in the US and in Japan for the past decade and
the one everybody should be worried about, is about more than just falling prices. Harmful deflation is
a situation of declining demand, falling prices, falling incomes, rising debt burdens, …, in which all
these elements reinforce each other. A predicament that is very hard to escape from.
Core inflation dangerously low
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Q. What causes harmful deflation?
A. Insufficient demand
Theoretically, deflation can be caused by central bank stupidity. If a central bank reduces the money
supply too much, this would lead to deflation. However, the appropriate policy reaction would then be
extremely straightforward: increase the money supply again.
The roots of truly harmful deflation lie in a lack of demand. The dynamics run as follows: insufficient
demand hurts the labour market, pushing up unemployment rates. This puts downward pressure on
wages and hence on prices. Downward pressure on incomes and especially higher job insecurity will
result in households increasing cautionary saving and reducing spending. Moreover, downward
pressure on incomes increases the real burden of debt (income, which determines the debt repayment
capacity, declines, while nominal debt levels remain unchanged). This leads to a rising number of
defaults, which spell trouble for the financial sector and result in reduced credit growth. In turn these
effects will bring down demand even further, and so on into a deflationary downward spiral.
Q. What’s the problem with deflation?
A. The debt-deflation spiral
The main problem with harmful deflation is that it erodes the debt repayment capacity in the economy,
while nominal debt levels remain unchanged. As such, deflation blows up the real debt burden with
obvious consequences for the number of defaults and the financial sector. This issue was painfully
illustrated in the US in the 30s. Between 1929 and 1933 the total level of debt in the US economy
exploded from 133.5% of GDP to 213.5%. This was entirely caused by the fall in nominal GDP, as in
the same period nominal debt levels were actually reduced from 142 to 122.4 bn USD. So even as the
entire economy cut back on spending to reduce debt, the real debt burden exploded. Because
everybody simultaneously tried to pay down debt, total activity declined faster than the debt reduction.
The total debt level in the US economy today is 342% of GDP. Against this backdrop the onset of
actual deflation would be disastrous. A debt-deflation spiral would be very hard to break.
Deadly debt levels
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Deflation
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Total debt in the US economy (% of GDP)
Q. What are the policy options to fight deflation?
A. Extremely non-conventional policy should be able to tackle deflation
As the root cause of deflation is a lack of demand, the appropriate policy response is obviously to push
up demand. However, in a deflationary context conventional monetary policy breaks down. The central
bank can lower its policy rate to 0%. However, the relevant interest rate for the economy is the real
rate. When inflation is negative, even with the nominal interest rate at 0%, the real interest rate will be
positive to the extent of the deflation and there is nothing the central bank can do about that.
Nevertheless, even at the zero bound the central bank still has options. These were highlighted by
current Fed-chairman Ben Bernanke in a 2002 speech ‘Deflation: Making sure ‘it’ doesn’t happen
here’. The main line of that speech was ‘under a paper-money system, a determined government can
always generate higher spending and hence positive inflation’.
Options when the fed funds rate is at zero:
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Lowering rates on government bonds of longer maturity by
o Committing to holding the overnight rate at zero for a specified period
o Announcing explicit ceilings for yields, which could be enforced by committing to make
unlimited purchases at those yields
Influence directly the yields on privately issued securities
Buy foreign government debt
Money-financed tax cut or public spending, aka the ‘helicopter drop’ (this would require
cooperation between the Fed and the Treasury)
The Fed has already tried the first two options and is probably looking to go further down that line
shortly. However, it is unclear how much pushing down interest rates any further from already very low
levels can do for the economy. In any case, the nuclear option is still open: printing money and giving
it to the government to finance direct spending. Such a move would be certain to generate economic
activity. If pushed far enough, this would certainly tackle deflation. However, at the same time it would
open an entirely new can of worms and almost certainly generate substantial turmoil in worldwide
financial markets. Moreover, managing the exit strategy from such a policy would be quite a challenge
later on (to put it mildly).
Q. Are the US or Europe heading for deflation?
A. Still not the most likely scenario, but especially in Europe risks are getting worryingly high
Both in the US and in Europe core inflation has fallen to dangerously low levels. Moreover, there is still
a lot of slack in both economies as illustrated by the significant outputgaps, subpar capacity utilization
and high unemployment. This is bound to put further downward pressure on inflation. Against the
backdrop of a very weak growth outlook (with downward risks) deflation has become a significant risk.
Extensive slack in the economy to put further downward
pressure on inflation
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US Average hourly earnings (lhs)
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US Unemployment rate (rhs, inverted)
However, at the moment income growth in both regions is clearly positive and this looks set to
continue (albeit at quite modest levels). This should prevent the onset of outright deflation. Moreover,
as Bernanke is an expert on deflation, it looks likely that the Fed will do whatever it takes to avoid such
a scenario.
In spite of a recent batch of better numbers, the risk of deflation actually looks higher in the eurozone.
Those better numbers are little more than an illustration of the usual delayed reaction of the European
cycle to developments in the rest of the world. In coming months the slowdown that is currently
happening in the US is bound to arrive in Europe. Moreover, the ECB looks very reluctant to even
think about the possibility of deflation, let alone act to counter it. Meanwhile, fiscal authorities
throughout the region are trying to outdo each other in announcing fiscal austerity plans. Finally, the
demographic glacier that will hit most industrialized countries in the next couple of decades has
already arrived in large parts of Europe. This all combines into a significant risk of deflation in the
eurozone.
Q. What does deflation imply for financial markets?
A. Not much good
If harmful deflation would take hold in developed markets only cash and very high-quality government
bonds would hold up. All other asset classes (equity, credit, real estate, commodities, gold, …) are
almost certain to suffer severe setbacks. Given the strong links throughout the world economy and
global financial markets, even countries that avoid deflation would be hit. So even emerging equity
markets would be seriously hit.
The helicopter-drop option should eventually be enough to fight off deflation, but at the same time it
would also entail substantial risks and cause great turmoil in financial markets. ‘Dropping’ large
amounts of money on a deflationary economy might get activity going again, ‘vacuum cleaning’ the
excess money at a later stage would be extremely difficult. One thing should be crystal clear, once
harmful deflation sets in there will be no easy or clean way out.
Even if both the US and Europe avoid deflation in coming years, which is still our baseline scenario,
the risk of deflation will remain relevant for markets for quite some time. Only when a sustainable
recovery really takes off, markets will be able to sound the all-clear on deflation. That is not something
that is about to happen any time soon. It is highly likely that markets will remain concerned about the
economic outlook and the risk of deflation for a substantial period of time. Periods of optimism or relief
will be followed by periods of disappointment and pessimism about the outlook for developed
economies. This implies markets are likely to remain volatile for some time to come.