Facing the deflationary threat

Michael Woodford Harold H. Helm Professor of Economics and Banking Princeton University Project Syndicate

Many central bankers are like the proverbial general who plans to fight the last war. But unlike backward-looking military strategy, flawed monetary policies produce inevitable damage, not merely worrisome risks.

Despite having conquered inflation, central bankers continue to fight it and as a result may fail to confront the latest economic menace -- global deflation. Falling prices have paralyzed Japan's economy for a decade. China and Hong Kong have seen prices plummet recently too. As the world's richest nations gather in Canada for the annual G-7 jamboree, their leaders should ask if the U.S. and Europe face a similar fate.

Deflation should not be hard to check, with sound policy. Some argue that rapid productivity gains from new technology, increased competition due to globalization, and the rise of internet-based electronic commerce created a world in which firms must steadily lower prices. But this thinking is based on a fallacy. Clearly, economic forces other than a country's monetary policy determine the relative prices that different goods and services should have -- and which they eventually do have, regardless of monetary policy. These forces do not determine the absolute price (in dollars, say) of any good.

The absolute price of any good is determined by monetary policy, in a way largely independent of the structure of relative prices. The only exception is when monetary policy is conducted in a manner that focuses on the prices of particular goods rather than on stabilization of a broad price index.

For example, the U.S. experienced chronic deflation at the 19th century's end. This was due to developments -- such as the growing number of nations on the gold standard -- that required the market price of gold to increase relative to prices of goods and services generally. Demand for gold increased, while supply was relatively constant.

Relative price changes could have occurred in two ways: Either the dollar price of gold could have increased or the dollar prices of all other goods and services could decrease. America's commitment to a rapid return to the gold standard prevented an increase in the dollar price of gold, so deflation ensued.

Much the same thing happens today. Hong Kongs declining attractiveness as a business center helped push down prices of locally produced goods and services relative to the prices of goods sold overseas. Again, relative prices could change either through an increase in the HK dollar price of internationally traded goods or through decreases in the HK dollar prices of local goods. Since Hong Kong's currency board prevents inflation in HK dollar prices, the HK dollar prices of local goods must fall. This would be unnecessary if Hong Kong adopted a monetary policy aimed at stabilizing a broad price index like the kind of policy pursued in the U.S., the euro zone, and most of the world.

But can central banks stabilize a falling price index as effectively as a rising one? Some economists argue that once deflation sets in, central banks are powerless because nominal interest rates cannot be pushed below zero. In a deflationary environment, this means that real interest rates -- that are all that matter for economic stimulus -- can not be pushed as low as might be necessary to boost demand and stem downward pressure on prices. The Bank of Japan's overnight interest rate has been essentially zero since 1999, but prices still fall.

Yet even in Japan, monetary policy could stimulate spending. Effective central banking is mostly a matter of managing expectations; for it is expectations regarding future policy, rather than the current level of overnight rates, that mainly determines long-term rates, other asset prices, and the exchange rate -- and hence spending and pricing decisions. When current overnight rates can no longer be lowered, it is vital that a central bank credibly signal its intention to maintain looser policy in the future, when it will have more room to maneuver.

For years the Bank of Japan (BOJ) failed to provide signals of this kind. It was more concerned with posing as an inflation- fighter. This misbegotten strategy culminated in the Bank's decision in August 2000 to abandon the zero interest-rate policy at the first signs of economic recovery, effectively declaring that it would not use monetary policy to bring about negative real rates after expectations of inflation returned.

The BOJ changed course a year ago when it committed to maintaining low interest rates until deflation ends. This was a timid but helpful initial step in the right direction. But an explicit price-level target would help more. Such a commitment would create definite inflation expectations (albeit not of continuing inflation). More importantly, to the extent that deflation continues, it would also automatically create greater expectations of inflation -- and thus greater stimulus.

In the U.S., the Federal Reserve has paid much more attention to managing expectations, resulting in an effective monetary policy. Indeed, financial markets end up doing much of the Fed's work for it. With clear and predictable communication of this sort, the risk that the Fed would be unable to free the U.S. economy from a deflationary slump is much lower -- and so is the risk that it would ever have to fight that battle. Other G-7 leaders might profit by seeking to apply this lesson more broadly.