FRBSF ECONOMIC LETTER Number 2004-08,April 2, 2004 Understanding Deflation Since the double-digit inflation of the 1970s, the This is because inflation as measured by regular Federal Reserve has consistently pursued the goal price indices is often biased upward; for instance, of price stability in the United States.And, since according to statistical analysis, the annual inflation the second half of 2002, the year-to-year increase rate as measured by core Personal Consumption in the core Consumer Price Index (that is, exclud- Expenditure (PCE) price index is probably biased ing the relatively volatile food and energy com- upward by about 0.5 percentage point, and the bias ponents) has been below 2%, which, according to can be even a bit higher when measured by core Fed Governor Bernanke, is probably the de facto Consumer Price Index (CPI).Therefore, when the equivalent of price stability (Bernanke 2003). measured inflation rate is below 1%, one cannot really tell for sure whether we are experiencing This development in the U.S. economy inflation low inflation or modest deflation. dynamics is unambiguously an important achieve- ment.However, last year, as the prospects for growth Another, perhaps more fundamental, reason for not remained uncertain, there were concerns that the making such a distinction is that, as the economy downward tendency of inflation might continue, swings from low inflation to modest deflation, the posing a remote, but still possible, risk that the dynamics of inflation and most other aspects of the inflation rate could fall to a level that is too low. economy do not change dramatically. In particular, For instance, the balance-of-risks statement issued in examining the potential costs to the economy, at the close of the FOMC meeting on May 6, 2003, there is no sharp discontinuity around the switch recognized explicitly that the probability of an point.Therefore, one may not need to separate unwelcome substantial fall in inflation, though these two scenarios in discussing the causes or the minor, exceeds that of a pickup in inflation from implications of deflation. its already low level. In thinking of deflation, one should keep in mind This Economic Letter examines the distinct features that the term describes only the dynamics of the of deflation, discusses why it is a matter of concern overall price level. It does not imply any specific to the public and to policymakers in general, and description of real economic activity.As a matter looks at the recent experience of the inflation and of fact, deflation can be accompanied by a weak deflation in the U.S. and other countries. economy as well as a by strong economy, and the recent experience of Japan and Germany illustrate What is deflation? this point. Figure 1 shows that Japan experienced a Let’s first be clear about the definition of deflation. contraction in real GDP accompanied by a fall in Deflation refers not to falling prices anywhere in the Consumer Price Index in 1998 and early 1999. the economy, but to a decline in the general price In contrast, Figure 2 illustrates that Germany experi- level across the economy. In other words, it is a enced a deflation (or very low inflation) in 1999 decline in the price level, not a decline in the growth and 2000, along with strong real GDP growth. Still, rate of the price level.The latter is often referred examples of deflation accompanied by economic to as “disinflation,” which means a decline in the strength are rarer in modern industrialized economies. rate of inflation. What can cause deflation? It also is useful to be clear that, for the purposes Macroeconomists generally agree that, in the long here, one need not make a strict distinction be- run, inflation and deflation are monetary phenom- tween the low inflation and the deflation. Part of ena. However, in the short run, many factors can the reason is that, in reality, it is hard to distinguish push the economy toward deflation. One type of between very low inflation and modest deflation. factor is a positive shock to supply in the economy. FRBSF Economic Letter 2 Number 2004-08,April 2, 2004 Figure 1 Figure 2 Japan: Real GDP and CPI Germany: Real GDP and Core CPI (Log change over prior 12 months) (Log change over prior 12 months) Percent Percent 5 6 4 5 CPI Real GDP 3 4 Real GDP 2 3 1 2 Core CPI 0 1 -1 0 -2 -1 -3 CPI -2 ex. fresh food -4 -3 96 97 98 99 00 01 02 03 96 97 98 99 00 01 02 03 For instance, a positive shock to labor productivity will tend to redistribute wealth between borrow- will put downward pressure on prices.This occurs ers and lenders when debt contracts are not indexed. because nominal wages and salaries are slow to Deflation also degrades the efficiency of the price adjust to unexpected changes in output per hour. system as resource allocator and adds complexity With output per hour rising faster than wages, unit to people’s and firms decisionmaking. It also dis- labor costs decline. In competitive markets, this will torts the tax treatment of capital because taxation induce firms to reduce their product prices, and generally uses nominal income rather than real the increase in general price level will tend to slow. income as the tax base. For instance, as shown in Figure 3, the productivity surge in the U.S. in the late 1990s boosted real When the economy is in a prolonged recession, a GDP growth while keeping the inflation rate on a deflation can be even more costly than an inflation, downward trajectory (“disinflation”).Another exam- as couple of factors may come into play and worsen ple of a positive supply shock might be a decline the situation. First, if the short-term nominal inter- in the price of oil. It is possible that if the positive est rate is already low, declining inflation and the supply shocks were prolonged, the inflation rate Federal Reserve policy actions to stimulate the would probably continue to fall and could even- economy may eventually push it toward zero. Be- tually lead to deflation, even while, at the same time, cause the nominal interest rate cannot be reduced economic growth might be quite satisfactory. further, worsening deflation would raise the real interest rate, effectively tightening monetary pol- Deflation also can be induced by negative shocks icy and discouraging consumption and investment. to aggregate demand.A negative shock that persis- Theoretically it may even further reduce aggregate tently affects aggregate spending, such as a contin- demand and the general price level, and continue ued decline in consumer confidence, will increase the downward spiral. Reifschneider and Williams slack in labor and product markets. High unem- (2000) describe this situation as a “deflation trap” ployment and low capacity utilization will then for monetary policymakers, because the conven- cause the inflation rate to decrease gradually over tional open-market operations alone will no longer time, until the economy returns to full employment. be able to stabilize the economy. Why is deflation costly? Second, the labor market adjustment may be more Deflation is essentially just the opposite of inflation. difficult. During a recession, unemployment is typ- Therefore, the reasons that inflation is costly will ically higher, as the demand for workers is weak. tend to apply also to deflation. For instance, like In order to boost employment, nominal wages need an unexpected inflation, an unexpected deflation to fall. But workers are typically very resistant to FRBSF Economic Letter 3 Number 2004-08,April 2, 2004 Figure 3 The situation could get even worse if the financial USA: Real GDP and Core PCE & CPI sector were fragile. As Bernanke (2003) pointed (Log change over prior 12 months) out, if the balance sheets of households and the cor- Percent porate sector are in poor condition and if banks 7 are undercapitalized and heavily burdened with nonperforming loans, deflation would increase the 6 real burden of servicing these debts, increasing the amount of nonperforming loans and worsening Real GDP 5 the balance sheets of both the corporate and the Core CPI 4 financial sector.This may “exacerbate financial dis- tress and cause further deterioration in the func- 3 tioning of the financial markets.” (Bernanke 2003) This process of “debt inflation” played an impor- 2 tant role in the U.S. deflation and depression in 1 1930s and it probably also played a role in con- Core PCE temporary Japan. 0 -1 Tao Wu Economist -2 96 97 98 99 00 01 02 03 References accepting wage reductions in nominal terms.There- [URL accessed March 2004.] forereal wages tend not to decline to the level required to “clear the market,” and, as a result the Bernanke, Ben S. 2003. “An Unwelcome Fall in Infla- job losses in this situation might be greater than in tion.” Remarks before the Economics Roundtable, a modest inflation.This may prolong the recession University of California, San Diego, La Jolla (July 23). http://www.federalreserve.gov/boarddocs/speeches/ on several counts. It could affect factors like con- 2003/20030723/default.htm sumer confidence, thereby weakening aggregate demand. It also could discourage firms from increas- Reifschneider, David, and John C.Williams. 2000.“Three ing employment, given that product prices and Lessons for Monetary Policy in a Low-Inflation Era.” profit margins are shrinking. Journal of Money, Credit, and Banking 32(4). ECONOMIC RESEARCH PRESORTED STANDARD MAIL U.S. POSTAGE EDERAL ESERVE ANK PAID F R B PERMIT NO. 752 San Francisco, Calif. OF SAN FRANCISCO P. O.