Central banks can stop worrying about inflation. Price deflation is far more likely in the near term. But temporary deflation need not be the terror that central bankers fear, at least if the banking system is recapitalized and if interest rates in industrialized countries fall sharply.
As recently as September and October, the US Federal Reserve and the European Central Bank (ECB) both saw the risk of inflation as being roughly equal to the risk to growth. Both were reluctant to lower interest rates markedly. Indeed, financial markets may have taken the Fed’s view on US inflation as representative of other central banks’ outlook on inflation, reinforced by the surprising ECB decision of Oct. 2 to keep interest rates on hold.
In October the US was on the cusp of the most significant turning point for inflation in the last 20 years. Of course, forecasting inflation is notoriously difficult. There have been large structural shifts in the world economy (for example, trade and financial globalization) as well as in individual economies (such as the decline in trade union power). Monetary policy itself has shifted to a far greater focus on inflation.
PRICE SHOCKS
Moreover, energy and food price shocks can be both large and largely unpredictable, while the speed of price changes tends to increase with big shocks. Most forecasting models used by central banks, therefore, put a large weight on recent inflation. This approach tracks inflation quite well, except at turning points, because the models miss key underlying or long-term influences.
The turning point that the US and world economy are facing is straightforward. Global output is probably falling faster than at any rate since World War II, except perhaps for 1974 and 1975. Under these circumstances, large excess capacity develops and commodity prices fall.
Indeed, it seems unlikely that governments in China and similar emerging markets can compensate swiftly enough to boost domestic consumption. And, with growing over capacity, investment in goods production may fall even further, with serious implications for GDP. Hence, demand for commodities, which has been driven by emerging-market growth, has fallen sharply, and helps decrease global inflation.
Eventually, lower commodity prices and lower inflation will act like a huge tax cut for households, allowing interest rates to fall further and thus stabilize economic activity. Paradoxically, the faster oil prices now fall, the shorter the subsequent period of deflation will be, as further damage to the economies of industrial countries is avoided.
Since oil and food prices have fallen sharply, and probably have further to fall, while unemployment is soaring, our models suggest that consumer price inflation, particularly in the US, must fall at record rates over the next six to 12 months. It is entirely possible that US inflation, measured over 12 months, will become negative by the middle of next year.
While some observers still fret about inflation risk, others are concerned that the usual monetary transmission mechanism is not working and that the US could face a Japanese-style “lost decade,” while others worry about a 1930s-style slump in industrialized countries.
STEMMING DEFLATION
So the policy debate now under way is about whether monetary policy can stem deflation and what happens if and when the “zero lower bound” on interest rates is reached. The zero lower bound arises because nominal interest rates cannot fall below zero. But if nominal interest rates stay positive, while inflation is negative, then real interest rates may become too high for an economy in recession, causing recession to become more severe and prolonged.
Deflation fears were mistakenly raised from 2001 to 2003, when the strong response of the US housing market and consumer spending to lower interest rates should have made the debate redundant. Influenced by a misreading of the Japanese experience, this led to excessive protection against the “tail risk” of deflation. Ironically, that policy response helped to fuel the credit and housing bubble, whose collapse has triggered the current recession, which may actually bring about deflation.
There are important differences between the structure of the Japanese and the US economies, including the enormously high level of liquid assets held by Japanese households, which tends to lead to lower consumption when interest rates fall. These differences, and the lessons that have been learned from Japan’s “lost decade” about the need to refinance the banking system, suggest that a “lost decade” for the US is most unlikely.
The policy implications outside the US and Japan, where rates are close to zero, are that central banks can safely cut policy rates and continue aggressive liquidity support operations with little risk of inflation.
In any case, with so little confidence in the financial system, and credit constrained by concerns about falling housing prices, the usual transmission channels from the policy rate have been blocked. Thus, the emerging emphasis on recapitalizing the banking system and more recently on unorthodox policies, including the purchase of private sector credit securities, is correct.
CONFIDENCE
As some confidence returns in an eventually recapitalized banking system and long bond yields decline with the fall in inflation, mortgage and other borrowing rates will fall and monetary transmission mechanisms will revive, supporting economic activity and stabilizing real house prices, albeit at a substantially lower level.
Finally, there are two major differences between the 1930s and the present.
The industrial world is now far more dependent on (mostly foreign) oil than it was then. The extreme rise in real oil prices was a major cause of the current recession and its reversal will be a major factor in the recovery. The other crucial difference is that we know enough not to repeat the errors — particularly trade protectionism — of the 1930s.
Janine Aron is a research fellow in the Department of Economics at Oxford University. John Muellbauer is professor of Economics at Oxford University and has been a consultant to the Bank of England, the British Treasury and the Office of the Deputy Prime Minister.
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