Deflation Spiral

Princeton University

Frankfurt, May 16th, 2012

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A Brunnermeier & Sannikov 2012 Types of inflation/deflation pressures . . Deflationarypressure Inflationary pressures Inflationary     “fear “fear driven”inflation Cost push driveninflation Demand driveninflation spiral Debt deflation Inside money creation and money multiplier collapses negative shock impairs balance sector of sheets systemic

at work mechanisms Different negative inflation Deflation more than is

“I Theory of Money”

Force 2 Force Force 1 Force

Brunnermeier & Sannikov 2012 Types of inflation/deflation pressures . . Deflationarypressure Inflationary pressures Inflationary     “Fear driven” inflation“Fear driven” Cost push driveninflation Demand driveninflation spiralDebt deflation      Central bank “cornered” is Inside money creation and money multiplier collapses negative shock impairs balance sector of sheets systemic Shift into real (“asset inflation”) assets People anticipate that central bank cannot counteract inflation pressures   Banking sectors suffers Banking debt overhandfrom sectors suffers Sovereign fiscal suffers price debtfrom overhang:of the theory level –

“I Theory of Money”

- inflation might snap

Force 2 Force Force 1 Force

Brunnermeier & Sannikov 2012 Force 1: Deflationary pressure Based on Based The I Theory of Money Risk to Negative Negative macro shock Assets (with Yuliy Sannikov) Risky Risky stake entreprens - free free piece intermediaries

net worth

deposits Liabilities

Brunnermeier & Sannikov 2012 Force 1: Deflationary pressure Risk to Negative Negative macro shock Assets Risky Risky stake entreprens - free free piece intermediaries

net worth

deposits Liabilities

Brunnermeier & Sannikov 2012 . . Deflation Spiral . Liquidity Spirals Force 1: Deflationary pressure Intermediaries are hit on both sides of the balance sheet of the balance are hitonboth sides Intermediaries Money: Capital:     Deflation collapses Multiplier Credit+ fire sales

depress prices depress

decrease

Risk to Assets Risky Risky stake entreprens

- free free piece intermediaries

net worth

deposits Liabilities

Brunnermeier & Sannikov 2012 . . . Deflation Spiral . Liquidity Spirals Force 1: Deflationary pressure systemic sector systemic KeyLesson: sheet of the balance are hitonboth sides Intermediaries Money: Capital:     Deflation collapses Multiplier Credit+ fire sales

depress prices depress

Deflationary pressure depends on health of on health depends pressure Deflationary

decrease

Risk to Assets Risky Risky stake entreprens

- free free piece intermediaries

deposits net worth

deposits Liabilities

Brunnermeier & Sannikov 2012 Force 2: Inflation expectation pressure . . Central bank is “cornered”is bankCentral Inflation expectations rise/snap expectations Inflation    bankagain. introuble increases whenmultiplier CB can’t react itwouldsince putsovereign debt sector Financial debt Sovereign  the price the price level Fiscal theory of  counter Japan

as - example

“Diabolic “Diabolic

Loop” or

systemic

Brunnermeier & Sannikov 2012 Force 2: Inflation expectation pressure . Inflation expectations rise/snap expectations Inflation    Economize Economize on use of money Investmentinreal assets bankagain. introuble increases whenmultiplier CB   Demand for money goes down, LM curve to shifts the right Term can’t react itwouldsince putsovereign premia

on nominal assets rise Multiple

equilibria velocity goes up velocity goes price asset

inflation or systemic

old, real estate real old,

Brunnermeier & Sannikov 2012 Forces 1 + 2 together . . . Deflationarymechanism Disagreement about size of both forces of both about size Disagreement Force 2: velocity of money increases Force 1     Realchanges + misallocations prices in+ distortions asset (outsidemoney money) not a to insideis substitute perfect : inside money supply declines inside money : supply 푌 푡

≠

−

inflationary mechanisminflationary

Brunnermeier & Sannikov 2012 Interest rate . . Only interest rate matters if rate matters Only interest Wealth      + complete Monetary Money of as store value (broadlydefined) (e.g.financialfrictions markets)incomplete moneyOtherwise supply can have impact Moneyfunction utility+ inthe  Affecting term spread, spread, risk Affecting term distribution is keyis distribution if markets. policy –

wealth distribution shifts wealth distributionwealth shifts

premia

separable

etc.

Brunnermeier & Sannikov 2012 Monetary Transmission Mechanisms . . New Keynesian “The I Theory”    “tail risk channel” “tail channel” redistribution“wealth Keynesian       “stealth “stealth recapitalization” of fragile sector systemic 푖 With financial frictions: No financial frictions: Frictions are reduced,butmoral hazard problem 푖 Reduceoverhang debt problem  ↘ ↘ Empirical Empirical link is for each mixed evidence ⇒ ⇒ 푝 푏푎푛푘 푏표푛푑 interest rate channel interest

푐표푠푡푠 ↗ ⇒ (with Yuliy Sannikov)

푏푎푛푘

↘

⇒

푒푞푢푖푡푦

푙푒푛푑푖푛푔 consumer EulerEquation + price stickiness ↗

⇒ ⇒ 푙푒푛푑푖푛푔

푖푛푣푒푠푡

(asset price) (asset

. / 푐표푛푠푢푚푝푡푖표푛 ⇒ 푖푛푣푒푠푡

. / 푐표푛푠푢푚푝푡푖표푛

↗

Brunnermeier & Sannikov 2012 Different ways to recap systemic sector . . . . Lowerrate interest Direct forced equity injectionDirect forced equity (SMP)programs purchase Asset CB       CB assumes CB risk assumes Stock: guaranteesExplicit Broaden collateral set Stock: Flow: (slow) assumes

capital gains capital gainscapital limited) is competition (if increasemargins lending tail

risk

푖

↗

⇒

equity

↗

…

tional Conven ventional Non - con

MP -

More targeted More transparent 14

Brunnermeier & Sannikov 2012 Ex . . . monetary policy (conventionalmonetary non and through recapitalization”“stealth anticipate Banks Way out: out: Way takeBanks risks on too much   - ante Moral Hazard banks strong but not Bolster the weak, andthe never Zombie strategy”) victimweak bankslet (“first default

- conventional)

Brunnermeier & Sannikov 2012 Only deflationary force only Instability Financial

Degree of intervention Degree of (inflation) Instability Price

Brunnermeier & Sannikov 2012 Adding inflation expectation force Instability Financial

d Termrisk ue to ue 휋 - risk premia

Degree of intervention Degree of (inflation) Instability Price

Brunnermeier & Sannikov 2012 If banks are less well capitalized Instability Financial

d Termrisk ue to ue 휋 - risk Limited/no room to maneuver premia

Degree of intervention Degree of (inflation) Instability Price

Brunnermeier & Sannikov 2012 Dispersion in inflation expectation . . Wellbankscapitalized Not well capitalized banks well Not capitalized 0 0

inflation inflation

Multiple Multiple

equilibria 19

Brunnermeier & Sannikov 2012 Ex . . . Avoidsuch situation endingupin Watch credit growth Watch regulation bank Strict      - ante: Preventive monetary policy Focus Focus measures on liquidity Monetary aggregates Maturityof credit matters to bankkeyrelative capitalis Credit aggregates variable Counter   Fixed capital Fixedcapital are requirement Be aware: Be aware: many alternative money like instruments - cyclicalitykey is

conterproductive –

Liquidity mismatch index! Liquidity

Brunnermeier & Sannikov 2012

Liquidity Mismatch Index (LMI) MismatchIndex Liquidity A Marketliquidity

    Private Agency MBS Overnight repo: Treasuries/cash

- label MBS:

λ λ λ λ liquidity promised through liabilitiesthrough promised liquidity

= = = = 1 .90 . .99 95

Brunnermeier, Gorton, Krishnamurthy

liquidity of assets liquidity

Fundingliquidity    Equity: Long Overnight debt:

- term debt:

Liquidity Mismatch minus

λ λ λ

= .10 = .50 = 1

Brunnermeier & Sannikov 2012 Liquidity Pockets . . . Sectorial LMISectorial Identify systemically important institutions important Identify systemically 20002008 to up build      Lowest LMIs are the systemically importantones LMIs are Lowest systemicallythe “financialintermediary” LMI<0 identifies financial is sector more (bad) negative Guess: (good), but LMI rises for liquidityAggregate Guess: Corporate, household sectors are long liquidity BankingGuess: short net sector is liquidity  But,to whom, how much, etc.

Brunnermeier & Sannikov 2012 Conclusion . . . . banks to recapitalize banks to avoid deflationary to avoid banks to recapitalize banks Weakmacro Researchagenda! identify to index help mismatch and liquidity aggregates Quantitative future in the inflation of opens flank fight Deflation to crediblefight CB forces (with fire     Dangers of liquidity spiral and deflation spiral spiraland Dangers deflation of liquidity Possiblejump inexpectations inflation Wealthchannelflow) vs. (stock redistribution KeynesianInterestrate channel

- prudential regulation forcesregulation central prudential - sales + default) sales

Brunnermeier & Sannikov 2012 • Monetarypolicy Driver Key friction Time consistency • Second order effects First

order effects order

Price & Price stickiness ZLB New Keynesian monopolistic Price + stickiness stickiness Wage price adjust (not)firms could which Redistributional to price stickiness due impact interest ratereal Nominal trade HH’sAffect sticky atdemand price firms asobliged are driven Demand - off

interest rateinterest

intertemporal

competition

between

to meet to

Financial friction I Moral - risk taking (bubbles) in leading moralhazard to Ex non and financial between effects Ex potential their firms/banksexploiting from problems and increases incentive funds Misallocation of

- Greenspan put put Greenspan Theory - - ante: post:

hazard -

redistributional insurance effect effect insurance financial sector

restrains

Brunnermeier & Sannikov 2012 Monetaryaggregates Theory Focus Monetarypolicy

Price Price stability Monetarism (Friedman) ofM2 growth Constant (Brunner, Meltzer) Intermediation are Inside moneyandoutside M1 M0 M Exogenous Transaction moneyrole of v*M P*Y = of money Quantity theory

perfect substitutes perfect 2( Friedman,Schwartz

)

Price Price and I pressure deflationarySwitch off monetarypolicy Recapitalize through banks meaningfula way) (difficult measure M1 to deposits lines underwriting Bank ( (intermediation) inside money substitute imperfect Outside money is only multiplier moneyendogenous valueStore of (liquidity, sheet) balance Distribution of wealth Financial stability - Theory ) is bankis substitute to )

credit for

- 3 in 3