Escaping the deflation trap to stabilize economy

Michael Woodford, Professor of economics, Princeton University, Project Syndicate

Deflation will be the overriding topic when America's Federal Reserve Board meets on June 24. Michael Woodford, one of the world's leading authorities on central banking, offers a strategy to break the grip of falling prices.

Alan Greenspan's recent speech to a conference of bankers in Berlin -- admitting the desirability of "insurance" against the risk of deflation in the U.S., even if it has not yet appeared -- focused attention on a crucial issue. What can be done to stabilize an economy when nominal interest rates cannot be lowered any further, but prices still fall and the output gap -- the difference between what it can produce and what it actually does produce -- remains wide? What was a theoretical curiosity raised by John Maynard Keynes in the 1930's has become the fundamental issue confronting policymakers in the world's largest economies.

Japan poses the clearest example of this problem. Growth there remains anemic, and deflation lingers, suggesting a need for monetary stimulus. But the benchmark interest rate in Japan has been essentially zero for the past four years, so the standard form of monetary stimulus -- reducing short-term nominal interest rates -- is unavailable.

With the Fed's operating target now only 1.25 percent and signs of recovery in the U.S. fragile, many now fear that the U.S. is poised to confront a similar situation. The recent cut in the ECB's policy rate amid warnings of possible deflation in Germany lead some to fear that the euro zone may be equally at risk.

Some economists recommend fundamental changes in the way monetary policy is conducted to avoid ever reaching this "zero bound" on interest rates. Paul Krugman, for example, calls deflation a "black hole": Once you fall into it, monetary policy becomes ineffective because no amount of monetary expansion can further reduce interest rates. So policymakers must prevent deflationary expectations from ever taking root by targeting a sufficiently high inflation rate at all times.

But what if it's too late, and the zero interest rate bound is reached while prices are falling? Is there any point in having an inflation target that cannot be met? Kunio Okina, director of the Bank of Japan's Institute for Monetary and Economic Studies, resists inflation targeting for this reason. He argues that "because short term interest rates are already at zero, setting an inflation target of, say, 2 percent wouldn't carry much credibility."

Wrong. The "zero bound" on short term rates does represent an important constraint on what monetary stabilization can achieve, but it is a more modest barrier than deflation pessimists insist. Monetary policy is far from powerless to mitigate a contraction in economic activity when deflation strikes, or when an economy flirts dangerously with it.

The key is to create the right kind of expectations regarding how monetary policy will be conducted in the longer term. For expectations regarding policy in the future determine the severity and duration of the output gap that results from hitting the zero bound now.

If the Bank of Japan, for example, were to commit itself to a target path for a broad price index, and credibly commit to keeping interest rates low until that target is reached, this commitment would influence investor behavior. For the more that prices fall, the greater should be the confidence in future inflation, and hence perceptions of lower real interest rates.

A commitment to a price-level target path above the current level would imply a commitment to keep nominal interest rates low for a time in the future, even after prices begin to rise again. A commitment to hold down nominal interest rates for a longer period of time should stimulate aggregate demand immediately. This is true even when current rates cannot be lowered any further -- and even if inflation expectations remain unaffected -- owing to the effects of the expected future path of short rates on current long term interest rates and on the exchange rate.

The fact that an official price level target is not hit immediately need not impugn such targets. The existence of an official target is crucial, even when it is not being reached, because it allows the private sector to judge how close the central bank is to a point at which it would feel justified in abandoning its zero interest rate policy. The current gap between the actual and target price levels should shape private sector expectations regarding how long interest rates are likely to remain low.

But why should the private sector believe that the central bank is serious about hitting its price level target, if all that is observed in each period is a zero nominal interest rate and another target shortfall?

Ideally, the best way to make its policy credible would be for the central bank to demonstrate its commitment to the price level targeting framework before the zero bound is reached. In practice, and especially when deflationary fears are already present, managing private sector expectations demands considerable subtlety.

The private sector is likely to scrutinize the bank's current actions for clues to its future behavior. So "signaling" effects, such as shifts in the central bank's portfolio towards long term securities, could help make the bank's price level target credible. If, say, the central bank starts buying long term bonds from the private sector at below market interest rates, this should help convince the public that the bank intends to stick to a future low interest rate policy.

Such asset shifts would work because the level of long term interest rates is an indicator of the markets' faith in the central bank's commitment to maintaining low short term rates once inflation returns. So, if the private sector is skeptical about the bank's commitment, long term rates will be too high. But if the bank buys long term bonds, it will tend to show that skepticism is unwarranted.

The stabilizing effect of such asset purchases is due not to any mechanical consequence of the shift in portfolio balances, but to a change in private sector expectations regarding future interest rate policy. Any central bank facing deflation should commit itself in advance to a price level target and pursue actions that convince the private sector that the commitment is genuine. Only that change in private expectations will make the bank's policy effective.