D1~IF~ SEPTEMBER/OCTOBER 0995 Christopher J. Neely is an economist at the Federal Reserve Bank of St. Louis. Geoffrey F. Wood is a professor at City University Business School in Landon and was a visiting scholar at the Federal Reserve Bank of St. Louis when this article was begun. Kelly M. Morris provided research assistance. “I argue for the inflation target because I Deflation and fear the consequences of having to aim to deflate the econotny half the time, Real Economic which is what the price level approach requires.” Activity Under Since the end of World War II, year-over- year declines in theprice level have been rare the Gold in the industrialized world; during the period of the gold standard, however, both long Standard downward trends in the price level and much shorter periods of falling price levels were 3 common. Ironically; although Irving Fisher Chrktoplier J. Neely and advocated a price level target precisely to Geoffrey E. Wood avoid the protracted downward (and upward) swings in the price level observed under a In the past few years, several countries gold standard, the experience of this period have announced explicit target ranges for provokes, in part, the criticism of price level I inflation. New Zealand did this in 1990, targeting today Perhaps more important for Canada in 1991, the United Kingdom in 1992, these beliefs about deflation is the deflation- and Sweden and Finland in 1994. Even when ary period (not examined here) from 1929 an inflation target is achieved, the future through 1933, in which the price level fell by price level is not easy to predict because none 20 to 30 percent. Bernanke (1995) argues of these countries has committed itself to persuasively that this price decline, caused reversing the consequences of shocks to the by the U.S. determination to stay on the gold price level. Indeed, in New Zealand there is standard, was a major contributor to the A price level is o weighted overage an explicit commitment root to reverse cer- severity of the Great Depression. This article of prices in o country. Price level tain such shocks. reexamines the facts surrounding temporary targets may be either constant over One alternative to inflation targeting periods of deflation that occurred under the twe (static) or hove a trend. In is price level targeting.’ The adoption of a gold standard from 1870 to 1913. We first this paper, we ose pica level torget~ngto refer to o static price constant price ]evel target would have several describe the behavior of price, money and level target. The sboded insert at advantages over an inflation target. Chief output data, then perform some simple tests pp. 34 ond 35 distinguishes price among these is that consumers and firms to determine whether output growth grew level ond inflation targets. could write simpler contracts and make more slowly during periods of falling prices long-run plans without worrying about and whether knowledge of a falling price 2 Pine Finopciol Times, Jane 24, inflation. Price level targeting also may level would, in fact, have helped predict lower 1994. Note that Fischer refers to static price level target. A price avoid the “time-inconsistency” problem output growth. Although we must be cautious o level target with a positve trend of an inflation targeting regime in that the about drawing conclusions from 100-year—old world on~reqeire the monetary monetary authority would have less incen- data generated under a much different mone- outhority to “disinf late’ half the tive to inflate the economy in a one—time tary regime, another look at this experience twa, thor is, to mr a rote of inflo’ bid to increase output temporarily Under is warranted because several countries have toe below the long’ron trend. a price level target, any “surprise” inflation adopted policies that are likely to he associ- Disinflaton is not the only poten’ must he reversed. ated with temporary periods of deflation. tol deowbock of price level targets. Critics of price level targeting argue The next section briefly reviews why Some oppose them becoose they that making a commitment to reverse sur- deflation may affect real output. A descrip- rnighr lend to groorer short-rev prise increases in the price level is undesir- tion of our data set and an explanation of nolotlity in the inflator rate. able because a fall in the general price level, our statistical tests follow, We then report °Periods in ‘which prices fall one or deflation, can have harmful effects. One the results of our tests, before concluding yeorwrer-yeor basis ore considered such critic, Stanley Fischer, put it this way: with some ideas for future work. pedods of deflaton. flDERAL RESERVE BANK OF ST. LOUIS 27 lltYIt~ SIPTEMRER/OCTOEEE 1995 3., despite evidence to the contrary, many econ- 4 An evcellent neview of these issoes omists continue to believe that some prices can he found in Mc(ollum 119891, are inflexible downward and that even tem- Chopter 9. Ohoninn and Stockmnn It is now widely accepted that there is porary periods of deflation might reduce 2 (forthcoming) consider rho conso’ no long-term trade-off between inflation and output through this channel. qeences of monetony shocks for the output or employment; the existence of a Bernanke andJames (1991) argue economy when some, hot not nIl, short-run trade-off, on the other hand, is not that deflation might alternatively affect prices one sticky. That paper also general])’ denied. There are several explana- the economy by increasing the real value of sets out severn enplonotions fan price stickiness in odditon to those tions for this trade-off: lags between actual and nominally denominated debt. For example, reviewed in McCollnm. expected inflation (see Flume, 1752; Fisher, a2percent annual deflation would translate 1926; and Friedman, 1968); misperceptions a nominal interest rate of 4 percent into a Borm 119951 finds henef its of about relative and general price shifts (Lucas, real interest rate of 6 percent. Increasing lower inflation in the form of higher 1972); and staggered wage or price setting the real rate of interest might promote debtor long’nnn growth in e cross’coentry (Fischer, 1977; Taylor, 1980).~ None of these insolvency and financial distress. study. Here, vie are concerned with shorr’ron eflects. theories, however, predicts that lowering the The opposition to price level targeting price level is more costly than lowering infla- from those who fear the results of deflation, See Wynne 119951 far a sorvey of tion, Nevertheless, prices have not fallen (by either because of downward price rigidity or price stckiress and Croig (1995) anything more than a trivial amount) in any the consequences of debt-deflation, makes fan evidence on wage rigidity. major economy since 1945. the stud) of the historical association between Advocntes nf this view might point The means by which deflation might output and deflation worthwhile. A review oat that neol woges nose sobston- reduce output, however, are often not explicitly of the eiodence nould he a first step in con- 3 tally dening the severe deflotion of stated. One view is that deflation interferes siderong whether a central bank should now 1 the Greet Depression. with the adjustment of relative prices because adopt a p ice ci el target. Varioes series enisted before pablo nominal wages or some prices do not adjust ceton of thor noleme, hot thoy downward easily If wages and/or prices are hod deficiencies that wene remo’ sticky downwards, a negative demand shock died los well as somo new data will tend to cause persistent unemployment permitted) by Copie nnd Wehbec as prices and wages are slow to fall as required See Copie and Webben fon discvs- to clear markets. With a sufficiently high sion of pnevioes series deficiencies inflation trend, relative prices can adjust to u e tu o set of data Thc fir t con- and how they ere remedied. lhe a negative demand shock without any actual sists of 44 annual oh eri.anons on money~ cneciol point is that these previoos prices having to fall. Because nnarkets work prices, interest rates and output tn the seies contained n sponioes trend. better with a little inflation, according to this United Kingdom fronn 1870 to 1913 The o There has recently been some dis- view output will be less variable over busi- period 1880-1913 is generally considered cossion of the neliobility of that net ness cycle horizons and, perhaps, even the heyday of the cla socal mt rnational pet series—see the intenchenge higher in the long run. gold standard. We end ahe sample before hetweenlrensley 11986, 19891 Critics of the theory of downward price the beginning of World \\ar I in 1914. The and Feinsteir (19891, and the dis’ rigidity point out that many wages and prices source for the monetars sero s o Capie and cnssion in Crafts, Leyboenne end Wehher (1985). ihe anterest atc is a short- Mills (19891—bet there seems to do, in fact, decrease, and that the extent to be general agreement that whotev’ which prices are sticky depends on whether term one from the last quarter of each year. er its deficiencies, it is the best people expect inflation. An atmosphere of The output sene is Feunstemns (1972) com- ovoiloble. overall price stability will make people more promise estnnn~teof GDP and, therefore, We dropped Jopon from the sample willing to accept reductions in their wages ho tcnplacnt prncc deflator Os used as rhe proce or prices. scrod All data are annual to conform to hecoose it did not hone a metelic There is mixed evidence from rnicroeco- standard dying the 19th centur~nnd thc n des nty of u ing annual GDP data.