Not general deflation but ASSET PRICE deflation (caused by bad monetary policy) harms the economy: 84th annual report of the BIS.

I’ve argued against the irrational fear of deflation.

Basically, there is good deflation and there is bad deflation. Bad deflation is INVARIABLY caused by mindless intervention by central banks to reduce interest rates, which creates unsustainable asset bubbles.

Now, a critical analysis by BIS – the consortium of all central banks – confirms this view. Are central banks beginning to see sense? Maybe the truth does win, in the end. I don’t think the US Fed has got this message, though.

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The costs of deflation: what does the historical record say?

Deflations are not all alike. Owing to the prevalence of price declines in the 19th and early 20th centuries as well as since the 1990s, the historical record can reveal important features of deflation dynamics. Four stand out.

First, the record is replete with examples of “good”, or at least “benign”, deflations in the sense that they coincided with output either rising along trend or undergoing only a modest and temporary setback. In the pre-World War I period, deflation episodes were generally of the benign type, with real GDP continuing to expand when prices declined (Graph V.D, left-hand panel). Average real growth in the five years up to the peak in the price level was roughly similar to the growth rate in the five years after the peak (2.3% vs 2.1%). In the early interwar period (mainly in the 1920s), the number of somewhat more costly (“bad”) deflations increased (Graph V.D, centre panel): output still rose, but much more slowly – the average rates in the pre- and post-peak periods were 2.3% and 1.2%, respectively. (Perceptions of truly severe deflations during the interwar period are dominated by the exceptional experience of the Great Depression, when prices in the G10 economies fell cumulatively up to roughly 20% and output contracted by about 10%. That experience is not fully reflected in Graph V.D, centre panel.) 

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The deflation episodes during the past two and a half decades have, on average, been much more akin to the good types experienced during the pre-World War I period than to those of the early interwar period (although identifying peaks in the price level during this period is much more difficult than in the earlier periods because the recent deflations tend to be fleeting). For the most recent episodes, the average rates of GDP growth in the pre- and post-peak periods were 3.6% and 3.1%, respectively, a difference that is not statistically significant.

The second important feature of deflation dynamics revealed by the historical record is the general absence of an inherent deflation spiral risk – only the Great Depression episode featured a deflation spiral in the form of a strong and persistent decline in the price level; the other episodes did not. During the pre-World War I episodes, price drops were persistent but not large, with an average cumulative decline in the consumer price index of about 7%. More recently, deflation episodes have been very short-lived, with the price level falling mildly; the notable exception is Japan, where price levels fell cumulatively by roughly 4% from the late 1990s until very recently. The evidence, especially in recent decades, argues against the notion that deflations lead to vicious deflation spirals. In addition, the fact that wages are less flexible today than they were in the distant past reduces the likelihood of a self-reinforcing downward spiral of wages and prices.

Third, it is asset price deflations rather than general deflations that have consistently and significantly harmed macroeconomic performance.^ Indeed, both the Great Depression in the United States and the Japanese deflation of the 1990s were preceded by a major collapse in equity prices and, especially, property prices. These observations suggest that the chain of causality runs primarily from asset price deflation to real economic downturn, and then to deflation, rather than from general deflation to economic activity. This notion is also supported by the trajectories of prices and real output during the interwar period (Graph V.D, centre panel), which show that real GDP tended to contract before deflation set in.

Fourth, recent deflation episodes have often gone hand in hand with rising asset prices, credit expansion and strong output performance. Examples include episodes in the 1990s and 2000s in countries as distinct as China and Norway. There is a risk that easy monetary policy in response to good deflations, aiming to bring inflation closer to target, could inadvertently accommodate the build-up of financial imbalances. Such resistance to “good” deflations can, over time, lead to “bad” deflations if the imbalances eventually unwind in a disruptive manner.

^ For formal evidence on this point, see C Goodhart and B Hofmann, House prices and the macroeconomy, Oxford University Press, 2006, Chapter 5, “Goods and asset price deflations”.