Editor's note: The following commentary is based on President Stern's
opening address to participants at the June 2003 Supply,
Demand & Deadlines economics workshop for journalists.
I am pleased to have this opportunity to talk with you about a topic
that, once considered the purview of economic history, has become
one of the most cited economic concerns of todaydeflation.
As I do so, I should caution that I'm speaking only for myself and
not for others in the Federal Reserve.
When I speak of deflation, I am using the economist's definition:
a sustained period of decline in a broad measure of prices, that
is, a persistent decline in broad price indices. By persistent I
mean not just a decline for one or two months or even one or two
quarters but a sustained decline in prices. And by a broad price
measure, I mean something like the consumer price index or the personal
consumption deflator. This description is what most economists mean
As best I can judge, from looking at a variety of reports, commentary
and analysis about deflation, the conventional wisdom is that while
the probability of deflation in the United States is low, the consequences
are possibly severe. The question I will address is the following:
Based on what we know about deflation, should this be the conventional
wisdom? In other words, does economic history, economic theory,
our understanding of financial markets and the stance of policy
lead to these concerns about deflation? My answer is, not entirely.
I will argue that the conventional wisdom about the real economic
consequences of deflation is questionable.
Let's start with what we can learn about deflation from history.
Probably the first thing that comes to mind, at least in the U.S.
experience when deflation is mentioned, is the Depression of the
1930s. Between 1929 and 1933 prices declined by roughly 25 percent,
while over that same period real (inflation-adjusted) gross domestic
product (also known as real economic activity) in the United States
declined nearly 40 percent. Clearly, this is an episode where deflation
was accompanied by a significant decline in real economic activity.
We don't call it the Great Depression for nothing. It was a very
difficult economic time. And if you use that bit of history, obviously
that's an experience that nobody wants to repeat.
A more recent economic experience that has raised concerns about
deflation's impact on real economic activity is Japan. The Japanese
economy has essentially stagnated over the last 10 or 12 years,
and some of those years have been characterized by modest declines
in overall price levels. This is perhaps a particular concern if
you put yourself back in the environment of the late 1980s and early
1990s. Japan had not only become the second largest economy in the
world, but also there seemed to be a consensus that the Japanese
had the "right economic model" and that they would soon
become the largest economy in the world. That was not the first
grandiose forecast to go awry and no doubt not the last, but I think
that was a good characterization of expectations at the time.
Historical experiences with deflation accompanied by a decline in
economic activity, however, are not the only ones we have had with
deflation. During the last quarter of the 19th century, roughly
1870 to 1900, prices on average went down modestly. Yet, that was
a period characterized by appreciable economic growth on average
in the United States.
And many other countries around the world over those years had a
similar experience. The last quarter of the 19th century was a period
of modest deflation accompanied by, on average, appreciable economic
growth and rising per capita incomes. Now admittedly, that was over
100 years ago, and one might wonder about the relevance of that
experience given when it occurred, given its age so to speak. It
would be nice to have an example that was relevant and that was
closer in time to the present. And we do.
Consider the recent experience in China. Over the last five years
deflation in China has been accompanied by substantial economic
growth. And I think there's little doubt that China has been the
beneficiary of what we economists would call a positive supply shock
or a positive productivity shock, which simply means you get more
output of goods and services with the same inputs. It's easy to
see why that's happening in China because they're moving to a market
economy. Before this move, they had a serious resource misallocation
problemthey had all sorts of resources doing very unproductive
Well, that's a quick summary of what I've been able to glean from
looking at several deflation episodes. I would have to say that
the historical picture is fuzzy and that without economic theory
to guide us, it will remain a blur. So now I would like to discuss
what economic theory might have to say about deflation.
Let me start with this: I think one thing theory says is that unanticipated
changes in inflation or deflation are likely to create more serious
problems than anticipated changes. And unanticipated disinflation,
which would just mean a decline in the rate of inflation, would
be a larger problem than anticipated disinflation. And in fact there
are many similarities between disinflation and, ultimately, deflation.
The 2002 annual
report of the Federal Reserve Bank of Cleveland goes to some
length to point out that many of the issues and problems that people
point to when they discuss deflation prevail in a world of unanticipated
disinflation equally well. I think that's something important to
bear in mind.
Now, why would unanticipated deflation (or disinflation or inflation,
but I'll confine myself to deflation for the most part) be a more
serious problem than anticipated deflation? One area where unanticipated
changes in rates of deflation can cause problems is in the labor
market, particularly if wages are sticky. History suggests that
wages frequently are slow to adjust, especially on the downside.
That is, nominal wages, current dollar wages, are rarely reduced.
If prices fall unexpectedly but firms cannot cut wages, then they
may lay off workers as a result.
But we have recently seen some downward wage adjustments in the
airline and steel industries, and I suspect that wages are more
flexible than they used to be. The reason is that variable pay contracts,
for example, those that include bonuses and commissions, have become
an important part of today's compensation packages.
What does that imply? Well, it implies that compensation is not
as sticky as it once was. And that means that unanticipated deflation
should not have as large an adverse consequence for employment as
it might have formerly. If that is true, it is an important observation.
The problem with wage stickiness is it's great for the people who
remain employed because they're pretty well compensated. But wage
stickiness puts the burden on the people who become unemployed,
or who already are unemployed, because it makes landing a new job
more difficult. Flexible compensation packages mitigate these problems.
Another negative effect of unanticipated deflation, and one that
is talked about a great deal, is that it results in arbitrary redistributions
of income and wealth. And what in fact happens, of course, is that
deflation transfers income to creditors from borrowers. Another
way of putting it, borrowers ex post find themselves paying higher
real interest rates than they expected to, and creditors find themselves
receiving higher real interest rates than they expected to.
Let me leave aside the question of how such unanticipated transfers
could affect the real economy (what borrowers lose, creditors gain;
there is no net loss), and just assert that they will. What I think
is interesting and important is that today financial markets work
sufficiently well to basically eliminate many of these arbitrary
For example, think about how the mortgage market works in the United
States today. It looks like you can almost always refinance or recontract
in that market. And what the effect of that refinancing or recontracting
is, is people wind up paying and receiving the "same old"
real interest rate, although nominal rates clearly have come down.
So you don't get in today's mortgage markets the same kind of arbitrary
redistribution effects, even if the deflation or the disinflation
is unanticipated, that you would get in a different institutional
Does this always work? Well of course not. For it to work pretty
well, home prices have to be stable or rising, otherwise refinancing
is pretty difficult. The second condition is you have to avoid the
zero boundthat is, mortgage rates falling to zero or close
to zerobecause once that happens your ability to recontract
is probably ended. But mortgage rates today are well above that.
So it's interesting that the mortgage market at least seems to have
the characteristics that enable borrowers and creditors to deal
with unanticipated changes in prices.
If you think about the market for consumer credit more broadly,
and I'm now thinking of credit cards, practices are somewhat similar.
You know you're always getting mailings that, if you've got credit
outstanding at 9.9 percent, you can refinance it at 7.9 percent,
or 7.9 percent at 5.9 percent or 5.9 percent at 3.9 percent. Last
year, I received several mailings where you could pay a $50 upfront
fee, and you had no interest expense for six months. Now, I didn't
calculate what the effective rate of that was, but it had to be
pretty low, especially if you had a large balance.
So it looks like on the consumer side, some of the things that we
typically worry about with regard to unanticipated deflation have
been mitigated. However, that seems to be less true in the markets
for corporate debt or corporate credit. If you issued corporate
notes or bonds without a call provision and you get surprised by
deflation, there's not a heck of a lot you can do about it until
that paper matures. We also know, or at least it's my strong impression,
that certainly the market for credit for small and medium-sized
business borrowers is nowhere near as well developed and as flexible
as the mortgage market I was describing earlier.
So that means that in the corporate market, it is harder to refinance
or recontract, at least for small and medium-sized borrowers. It
means if you misjudge the rate of price change and if you misjudge
the prospective rate of growth of revenues, top-line growth, you
may indeed find yourself with a debt burden that's more difficult
to service than you had anticipated. And this may be the intuition
behind the concern over the so-called debt overhang or debt deflation.
It seems to apply mostly to, at least as I survey the financial
markets, the corporate market and more likely the markets for credit
for small and medium-sized business. And maybe this is one reasonand
anecdotally there is some support for thisthat capital spending
has been sluggish even though the economy has been growing over
the last six quarters or so. By the way, if my description is more
or less accurate, it suggests that the solution should rely upon
structural and institutional changes in the market for corporate
credit. It's not much a matter of monetary policy, and there have
been efforts from time to time to standardize that market to a greater
extent than it has been so far.
There is another thing that I think economic theory tells us. It
is that the underlying cause of the deflation matters. If, on the
one hand, the deflation is a result of a positive supply shock,
positive productivity growth, then it's benign. And we need not
worry about it, and we need not think about policies to offset it.
If, on the other hand, deflation is a consequence of a negative
shock to aggregate demand, so that the demand for goods and services
unexpectedly falls below what had been anticipated, that could be
a more serious problem.* Consequently,
before we act, we need to identify and understand the cause of the
What about anticipated deflation? Let me make another observation
that comes from economic theory. The size of the deflation matters.
In virtually all well-developed theories of money, anticipated,
small deflations are optimal; that is, a small deflation is the
best we can do, even in the presence of rigidities and wage stickiness.
However, anticipated, large deflations are suboptimal, because they
lower economic growth as savers invest in the high-return assetmoneyrather
than invest in real capital. My point is that, according to theory,
What do these various observations from history and from theory
and about how markets work suggest for the U.S. economy today? Obviously
the reason I'm talking about this is that deflation has become an
issue of the moment. As I suggested earlier, there is a conventional
wisdom, which I hope I've characterized reasonably, that suggests
that the probability of deflation in the United States is low, but
the consequences of deflation, should we experience it, are possibly
severe. Now the phrase "probability of deflation is low"
is obviously imprecise; it's not very rigorous and I'm not going
to try to clarify that this evening. But what I will say is I think
that judgment is probably correct in our current circumstances.
I think it's likely correct for a variety of reasons, some of which
I've already described. First, by most measures that matter, monetary
policythe policy that we at the Federal Reserve have been
pursuinghas been accommodative. That's evidenced by the way
interest rates have behaved, and also by growth in the broad measures
of money, which has been reasonably rapid. Clearly we have had stimulus
coming from fiscal policy and more is on the way. And whatever you
may think of the long-run budget situation, in our immediate circumstances
stimulative fiscal policy seems appropriate. Third, we have had
in the United States continued growth in income and improvement
in wealth, certainly coming from appreciation in house prices and
from improvement in equity values at least in recent months. All
of those things suggest that deflation in the near future is unlikely.
Let me move on to the second part of the conventional wisdom, namely,
that the consequences of deflation, should we experience it, could
be severe. Well, if you looked at the Depression for your "inspiration,"
you would answer yes, the consequences could well be severe. And
Japan might provide the same answer, although I think it's important
to note that really all that Japan has experienced as far as I can
judge is stagnation and occasional bouts of deflation. It's certainly
nothing rivaling the Depression of the '30s. Further, Japan's recent
problems may be due to rigidities and resource misallocation. Too
many resources are devoted to declining or contracting industries.
The Japanese have been unwilling to make or encourage or facilitate
the resource reallocations that need to occur for the economy to
In any event, the U.S. economy does not, in my opinion, suffer from
the rigidities, resource misallocations and financial problems of
the Japanese economy. And so I don't think Japan presents us with
a particularly relevant example of what can happen. It seems to
me the two economies are fundamentally so different that I would
be remiss if I didn't point that out.
I also want to point out, and I think this is pretty well recognized
by now, that beginning in the 1990s the U.S. economy experienced
a positive productivity shock, one that has persisted to this day.
It certainly has not been of the size of the supply-side shock that
has occurred in China as best I can judge. Nevertheless, these are
two large economiesours and China'sthat have had significant
positive supply shocks.
And finally, if we go back to the Depression of the '30s, it's still
a subject of intense economic analysis and research even though
it occurred 70-plus years ago. There is not a consensus about the
causes of the Depression or what could have been done about it.
But one thing that most people agree about is that one of the causes
of the Depression was a mistake in monetary policya mistake
by the Federal Reservethat allowed the money supply to contract.
And that was a serious error and one that we will certainly not
So to try to sum this up: I agree with the conventional wisdom that
the probability of deflation is low. The severity question to me
is murky, whether you come at it from the historical side or you
come at it from the theoretical side, or if you come at it from
the more practical institutional side. But as a policymaker, of
course, I have to worry about what can really go wrong. And for
that reason, even if the evidence were more preponderant one way
or the other, I think deflation is a subject that is well worth
our attention and well worth our concern.
* An issue I did not address at
the journalism workshop but one worthy of serious reflection is the
potentially limited effectiveness of monetary policy if the economy
experiences a negative demand shock and interest rates are already quite