Ever since the Asian financial crisis hit and recessions spread across many Pacific Rim economies, observers have worried that the U.S. economy was headed for a dangerous deflation. Is this worry justified? Price declines limited to commodities, real estate or the stock market are not uncommon and would not seriously disrupt the economy. They have happened many times and will happen again. By contrast, a widespread price deflation associated with a collapse of aggregate demand is dangerous and could contribute to a downward spiral of output and employment as it did in the early 1930s. But such a deflation is not a realistic worry today. The economy seems headed for a slowdown, not a recession. Should a recession threaten, the Federal Reserve can respond. If its response is tardy or timid, we could even suffer a mild recession. Such a sequence of bad surprises and bad policy reactions is not likely to happen, and would not produce widespread price declines if it did. A collapse of demand big enough to threaten a dangerous deflation is a truly remote possibility.
POLICY BRIEF #41
Not so long ago, policymakers were preoccupied with avoiding inflation. As the U.S. unemployment rate approached 6%, most analysts warned that markets were growing dangerously tight, and the Federal Reserve Board pondered whether to step on the monetary brakes in order to keep the economy from overheating. Having now reached the economic nirvana of near price stability along with 4.5% unemployment, the new worry is inflation's opposite: deflation and its particular dangers. These concerns first surfaced with the Asian financial crisis, the prolonged weakness in commodity prices, the deepening recession in Japan, and the seeming commitment of policymakers throughout the industrial world to fighting inflation and promoting fiscal consolidation. The uneasiness intensified this summer as world stock markets dropped, Russia defaulted, and the financial crisis seemed about to destabilize some countries of Latin America.
Once markets turned up in October in the wake of a slight easing by the Federal Reserve and some better news out of the Pacific Rim, the gravest concerns were muted. Still, many of the problems and uncertainties of the summer remain unresolved, and there is little reason to believe that the bad surprises from abroad and from financial markets are all behind us. One continuing worry is the risk of recession in the U.S. economy, and this risk merits the close attention of policymakers. However, predictions of a dangerous deflation are misplaced.
Deflation and Its Consequences
An important point about deflation is that some occurrences are not as harmful as others. The two damaging episodes of deflation in this century were the sharp drop in overall consumer prices during the recession that followed the First World War and the widespread price declines that came with the collapse of production after 1929 (figure 1). Such broad and deep price declines are precipitated not by competitive pricing in healthy economies, but rather by severe contractions in aggregate demand.
In episodes such as these, deflation helps feed the contraction in demand and real activity that initiated it. The unexpected price declines hurt borrowers, increase bankruptcies and foreclosures, and threaten the solvency of banks, which are then forced to restrict credit. As the expectation of falling prices takes hold and interest rates cannot adjust adequately, even buyers not dependent on credit hold back on spending. Through these channels, the 25% drop in consumer prices in the four years after 1929, along with the even sharper drop in wholesale prices, fed the downward spiral of real activity that was the Great Depression.
Mild and anticipated deflations have been less disruptive. Throughout much of the last quarter of the nineteenth century, a period when productivity rose rapidly and investment opportunities were abundant, broad price measures fell gradually. Though not posing the dangers of a severe general deflation, chronic gradual deflation of this kind would compromise economic performance today. With little productivity growth in the service-like sectors that now dominate the economy, prices cannot fall unless wages fall. And moderately rising average wages are needed to allocate labor efficiently. In addition, low real interest rates may be needed to escape recession, and these cannot be achieved with falling prices. Fortunately, monetary policy can easily avoid a chronic deflation and its disadvantages.
Prices in particular sectors fall far more often than the general price level, and such sectoral declines are less troublesome to the macroeconomy. Deflation in commodity prices is a common reaction to a slump in world demand or to an increase in commodity supply. Over the past year declines in farm prices and prices of oil and industrial commodities have hurt individual producers here and abroad and have even created macroeconomic problems in Russia, Indonesia, Mexico, Venezuela, and other countries that rely heavily on the export of such commodities. By contrast, the diversified economy of the United States has not been greatly affected, except insofar as these lower prices have benefited U.S. consumers.
Deflation in asset prices—real estate and stocks—are also quite frequent. In Japan, with its now infamous financial structure, the bursting of stock and real estate bubbles severely damaged the entire banking system and destroyed the net worth of many corporations. In the United States, such events have posed no serious risks to the banking system since regulations were tightened in the 1930s. The biggest problem came with the thrift crisis of the 1980s, when more than 700 savings and loan institutions had to be liquidated at a net cost of $155 billion. That episode induced regulators to tighten bank capital standards in the early 1990s, which some analysts believe contributed to the slow recovery from the 1990-91 recession. The crisis itself had only minor effects on overall credit availability and did not disrupt the broader economy because, in contrast to the situation in Japan, the bad loans represented only a small fraction of gross domestic product (GDP) and did not threaten the solvency of major banks.
Of these several categories of deflation, only the first—sharp general price declines that accompany and worsen recessions—would pose special dangers to the macroeconomy, by threatening a downward spiral in activity that could be difficult to correct
As a matter of arithmetic, we are not far from generally falling prices today. Over the past six quarters, the producer price index (PPI) for finished goods has dropped at a rate of 1.1% and the core PPI, which excludes the volatile food and energy components, has been barely rising. Even the consumer price index (CPI), core CPI, and GDP price deflator broader—price measures that include services where productivity growth is slow—have been rising less than 2% a year. This virtual price stability has existed with the economy growing briskly and labor markets tight. Experience teaches that recessions bring down inflation rates, so a recession today would seem to risk pushing them below zero.
However, recessions have produced large declines in inflation when inflation rates were high going in and little change when inflation was low to start with (figure 2). So a typical recession today would slow the already low CPI inflation rate by only a little. This projection is supported by what we know about labor markets. Individual firms cut wages only when facing severe financial hardship that threatens their existence. A massive recession that endangered the solvency of many firms could increase the incidence of wage cuts correspondingly. Yet even in Japan, which has been in a protracted slump throughout the 1990s, average wages in manufacturing last year rose 3%. Because labor costs are three-fourths of net value added by nonfinancial corporations, this resistance to wage declines puts a floor under the general price decline that could be expected in all but the most severe economic downturn.
Pre-recession inflation rate (%)
Notes: 1948-71 data are CPI less food, 1971-92 data are CPI less food and energy. The 1974 recession is omitted because of the effect of price controls and their removal. Because of these controls, introduced in August 1971, the annual rate of inflation between 4Q1970 and 2Q1971 is used for 1971.
Today, that general inference is buttressed by other evidence. First, average hourly wage and salary costs have been rising by 4% a year, a rate that has already been squeezing profit margins. Even with a generous allowance for productivity growth, trend unit labor costs are rising by 2% a year and would slow only gradually in a recession. Second, price inflation over the past year was pulled down by a rising dollar, falling oil prices, and Asian currency devaluations, all of which helped reduce import prices by 5%. Even if the sharp drop in import prices is not reversed, it is unlikely to be repeated. All this suggests an extended period of even moderately declining prices is unlikely. A sharp and damaging general deflation is a truly remote possibility.
Whether the United States is on the brink of deflation is actually the wrong thing to be worrying about. Long before deflation ever became a serious concern, the country would be facing a recession, which would itself be a calamity in a world already suffering from severe downturns in Asia and financial risks throughout the emerging market economies. The right questions to ask are what are the prospects of recession, and are policymakers prepared to respond promptly and aggressively to any such threat?
In mid-1998 recession seemed unlikely. The economy was expected to slow to around its trend growth rate of 2% to 2.5% a year, and it was a toss-up whether the Fed would have to increase rates. Then, the Russian default increased the chances that the Asian crisis would spread to Latin America, an important market for U.S. exports. The outlook for Japan's economy worsened as its leaders stumbled in their attempts to clean up the banking crisis and to produce a more expansionary fiscal policy. And on the financial front, banks and other financial institutions revealed large losses in risky portfolios, and stock markets in the major industrial economies fell sharply through the first part of October. At that point, recession worries became more widespread, not only because it seemed that foreign economies would weaken further, but also because many observers believed that the markets must be signaling bad times ahead or that big stock price declines or the financial problems of banks could weaken the U.S. economy, adding to the downward pressures from abroad.
Though the rally in stock prices after early October eased those concerns, the sensitivity of markets to new developments provides little assurance they will not fall again in today's environment. So it is worth examining the plausible links between markets and the real economy. The direct effects of a market decline would come from raising the cost of capital to firms and reducing the wealth of consumers. Because the cost of equity capital is only one of many determinants of business investment and because it can be offset by lower borrowing costs, most attention centers on the effects of wealth on consumer spending.
A commonly cited historical relation between total wealth and consumption can explain two percentage points of the three percentage point decline in the personal saving rate that occurred between 1995 and the summer of 1998—about $120 billion of added consumer spending. By this reckoning, a market decline that reversed the gains of the past three years—a decline about twice as large as the drop from the market's July high to its October low—would cut spending by a like amount, or about 1.5% of GDP. But this is a large overestimate, because the projected consumption loss takes no account of who owns stocks. Historically, stock ownership has been so concentrated among wealthy individuals that the ups and downs in the market have affected only a few people's spending. Despite the spread of retirement accounts invested in equities, ownership is only a little less concentrated today. This suggests the bull market did not cause the recent decline in the personal saving rate, and a reversal of those market gains would not cause a comparable decline in personal consumption.
Rising risk premiums provide another potential link from financial problems back to the U.S. economy. After the Russian debt default and the collapse of long-term capital management, the flight to quality in financial markets accelerated, doubling the interest rate premium between junk bonds and Treasuries and widening the spread of commercial paper rates over Treasury bills. These spreads have narrowed as pessimism has receded. But should financial problems reemerge, they could further reduce the credit that banks and other sources would make available to firms. The Fed's prompt response to the problems that have already appeared—its sponsorship of the rescue of long-term capital management and the three small rate cuts it has already made—shows it is concerned by these risks.
The other pieces of the outlook puzzle are mixed. Over the most recent four quarters, real GDP grew by a rapid 3.6%, despite a sharply declining trade balance that subtracted 1.3% from GDP. The trade balance is likely to decline less over the coming year. The huge deterioration in exports to the Pacific Rim has leveled off in the past several months, and imports should rise less rapidly in the face of a slowing economy. Consumer spending will certainly not grow as fast as it has been, but it should keep up with moderately growing incomes. Even allowing for some softness in business investment and home construction next year, the pieces add up to an economic slowdown but not to a recession unless the surprises are all on the downside and policy fails to respond.
Alongside this assessment of the economy's most likely path, it is important to recognize that uncertainty has grown, and large negative shocks to the economy would not be all that surprising. The most visible risks are that a currency crisis in Brazil could deepen its recession and harm all Latin American economies, and that the rapid decline in Japan's economy will continue in 1999. With the emerging world's financial system still fragile, problems could also emerge from other directions. In this uncertain environment, there are questions about how promptly and decisively nations would respond to new signs of trouble.
The United States, Europe, and Japan represent 70% of world GDP. In Japan, plans for fiscal stimulus and repair of the banking system have been painfully slow in coming and could still be inadequate. In the United States, the president's behavior and Kenneth Starr's relentless stalking of him, and now the impeachment process, have polarized the political process. If fiscal stimulus were needed next year, getting it would be delayed and compromised by bitter partisanship. In Europe, authorities may be slow to respond to a threat of recession because of monetary union with its fiscal rules and new central bank. Even if the center-left governments that recently came to power in France, Italy, and Germany are more willing than their predecessors to bend those rules, the new environment could still delay them. And it remains to be seen how aggressively the new Eurobank will use quick-response monetary policy. Led until now by the Bundesbank, European monetary policy has historically been tolerant of high unemployment and focused on inflation fighting and keeping the deutsche mark strong. There is a risk that the Eurobank will set out to show that its priorities are just as conservative.
U.S. Monetary Policy
Fortunately, the Federal Reserve remains unencumbered by any of these problems. It deserves credit for steering cautiously through the present long economic expansion. However, it now confronts different risks that could require large and prompt actions to provide liquidity, reduce borrowing costs, and head off any buildup of negative expectations. With the federal funds rate still at 4.75%, there is ample room for such actions should they be needed.
Two considerations could complicate the Fed's deliberations if the economy appeared to be faltering next year. First, some observers believe that insufficient monetary restraint has led the stock market to unsustainable levels and that aggressive easing would add to financial market excesses. The rapid recovery of the market after the Fed's rate cuts this fall will add to these concerns. If it were inhibited by them, the Fed could reduce the risks by raising margin requirements on stock purchases. Some have argued that modern financial derivatives would make raising margin requirements ineffective. According to others, raising them would be overkill that would crash the market. The truth is likely somewhere in between. It is puzzling that Alan Greenspan never chose to raise required margins while voicing his concerns about the market's irrational exuberance in the past.
The more likely hurdle in the way of decisive easing is the desire to avoid a renewed outbreak of inflation. It is telling that members of the Open Market Committee were worrying about inflation this summer at the same time that some business and financial leaders were worrying about deflation. If the U.S. economy continues to grow, a modest pickup from the recent near-zero inflation rate would not be surprising. But a modest positive inflation rate is not a problem and actually helps sustain high levels of employment. Should a greater inflation danger emerge someday, that will be the time to deal with it. Especially in today's world, the top priority must be to ensure that growth continues.