Downside Danger

If a single proposition unites central bankers these days, it is the belief that price stability — in practice, a low and stable rate of inflation — is the bedrock of sound monetary policy. To someone with only a passing knowledge of monetary and economic history, this idea may seem unprogressive, if not downright Victorian. In fact, its validity has been demonstrated, painfully, many times.

There is now a consensus among economic historians that a particular form of price instability — deflation, or falling prices — was a principal cause of the Great Depression. And nearly all economists agree that the inflationary surge in the United States, the United Kingdom, and several other countries from the late 1960s through the early 1980s was an important source of the economic volatility, slow growth, and high unemployment that characterized those years.

Determined to avoid a repeat of the Great Inflation of the 1970s, central bankers around the world have worked hard over the last two decades to achieve price stability. The U.S. Federal Reserve has reduced inflation from more than 13 percent in 1979 to the low single digits today. As part of the anti-inflation campaign, many central banks have adopted quantitative inflation objectives, including several banks, such as the European Central Bank (ECB), that do not formally classify themselves as "inflation targeters."

Nearly all industrialized nations currently have inflation rates of around 2 percent, the important exception being Japan, which is experiencing a mild deflation. Even regions traditionally prone to high inflation have substantially reduced their inflation rates. For instance, many countries in Latin America now boast rates well below 10 percent; very few have rates above 20 or 30 percent, a once common level.

Low and stable inflation in many countries is an important accomplishment that will continue to bring significant benefits. But de facto price stability has had another effect, which is now forcing central bankers, as well as the public, to fundamentally rethink inflation.

After a long period in which the desired direction for inflation was always downward, the industrialized world’s central banks must today try to avoid major changes in the inflation rate in either direction. In central bank speak, we now face "symmetric" inflation risks. The Federal Reserve recognized the changed circumstances in a statement issued following the May 6, 2003 meeting of its policymaking arm, the Federal Open Market Committee (FOMC). The FOMC explicitly recognized that both upside and downside risks to inflation can exist and said the greater risk at this moment is on the downside. It was the first time in decades, if not ever, that the central bank has voiced concern that inflation might fall too low.

Why would very low inflation — say, below 1 percent — or actual deflation (negative inflation, or falling prices) possibly hurt the economy?

The potential harm of very low inflation or deflation depends on the economic environment. Deflation can be particularly dangerous when a financial system is shaky, with household and corporate balance sheets in poor shape and banks undercapitalized and heavily burdened with bad loans. Under such conditions, deflation increases the real burden of debts — that is, it forces borrowers to repay in dollars that are more expensive than the dollars they borrowed — and may exacerbate the financial distress. (Unexpectedly low inflation has a similar effect.) This phenomenon, known as "debt deflation," factored prominently in the global economic turmoil of the 1930s and may have played an important role in Japan’s recent troubles. Fortunately, the United States does not appear at risk of suffering a similar financial setback. American households and firms have done an excellent job in recent years of restructuring their balance sheets, and U.S. banks are well capitalized and profitable.

Although the U.S. financial system is sound, circumstances exist under which deflation or very low inflation might still conceivably pose a significant threat to the economy. The potential problem could arise when aggregate spending by households and firms is insufficient to sustain strong economic growth, even when the short-term real interest rate (the market, or nominal, interest rate minus the rate of inflation) is zero or negative.

When aggregate demand is that weak, deflation or very low inflation places a lower limit on the real interest rate that can be engineered by monetary policymakers — in other words, it hinders the ability of a central bank to stimulate growth. That is because the nominal rate of interest cannot go below zero. No one will lend at a negative interest rate; potential creditors will simply choose to hold cash, which pays zero nominal interest.

The U.S. economy appears to be rebounding, in part because the Federal Reserve has kept interest rates low. I expect the recovery to continue. But were it to falter — say, because firms cut back on new investment — then the scenario just described might become relevant. Specifically, if spending and output growth next year proved insufficient to absorb the slack in labor and product markets, we might see further reductions in inflation, which would further restrict the Federal Reserve’s already limited ability to lower the short-term real interest rate.

There are other ways the central bank can stimulate the economy. For example, it can purchase a broad range of financial assets, thereby pumping additional liquidity into the economy. However, the Federal Reserve has less experience using these methods and in predicting their effects, so implementing them would not be without cost. Hence, allowing inflation to fall too low — low enough to where it might morph into actual deflation — would be highly undesirable from the point of view of the Federal Reserve, or any other central bank for that matter.

In short, inflation can be too high, but it can also be too low. So what level of inflation is just right — what, if you will, is the "Goldilocks" level? The best-case scenario is when inflation is neither so high as to impede economic efficiency and growth nor so low that the nominal short-term interest rate routinely flirts with zero. What that ideal inflation rate is depends on the individual economy and on the views and preferences of policymakers.

Although the "just right" inflation rate for the U.S. economy remains an open question, much recent research suggests that it is around 2 percent. Japan’s negative inflation rate is clearly too low for the country’s economic health. Until recently, the ECB’s inflation objective was a rate below 2 percent, leading some observers to worry that the bank was perhaps giving insufficient attention to the downward risks to inflation. Lately, however, the ECB has stated that it intends to keep inflation near 2 percent, which suggests that it is now taking a more symmetric view of inflation risks.

The conquest of inflation is an important victory for the world’s central banks and a critical factor behind the improvement in economic performance over the last two decades. To continue to promote economic growth and stability in coming decades, monetary authorities will need to exercise the same vigilance with respect to the downside risks to inflation.