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short essays and reports on the economic issues of the day
2003 ■ Number 8

Symmetric Inflation Risk
Abbigail J. Chiodo and Michael T. Owyang
t is generally presumed that a reduction in the inflation
rate, i.e., disinflation, is beneficial to the economy
because high inflation raises the cost of holding money,
increases the frequency of costly price changes, and lowers
the value of nominal incomes. Disinflation can impose
costs, however, and outright deflation—a sustained fall in
the general price level—can be disastrous. A decrease in
inflation causes real interest rates to rise, which can dissuade firms from committing to long-term investment
spending and lead to lower output growth, which, in turn,
can put further downward pressure on prices. Unanticipated
disinflation is costly to bearers of long-term debt who, when
borrowing, forecast higher inflation rates. These costs are
incurred because disinflation increases the value of the
dollars that borrowers must pay back relative to what borrowers had expected.
Policymakers all over the world have judged that the
benefits of lower inflation outweigh the costs of a decline
in the inflation rate when the rate is high. However, once
price stability has been achieved—when the inflation rate
is near zero—continued disinflation will result in deflation
and impose significant costs on the economy. Recent experience in Japan (as well as historical experiences in the
United States and elsewhere) illustrate the problems that
can arise from sustained deflation. When inflation was low in Japan during the late 1970s
and 1980s, output growth was smooth. The
persistent deflation since the 1990s (Japan’s
average inflation rate between 1993 and 2002
was –0.2 percent) has been combined with slow
growth and volatile fluctuations in output.
The figure shows the rise and fall in U.S.
inflation and interest (federal funds) rates
since 1978. Economic theory tells us that
there is a one-to-one positive relationship
between the inflation rate and the nominal
interest rate. During the period 1978 through
1986, for example, the average inflation rate


(measured by the GDP deflator) was 5.7 percent. Over that
same period, the federal funds rate averaged 10.6 percent.
Recently, however, the inflation rate and the federal funds
rate have been considerably lower. Between 1995 and 2002,
the average inflation rate was only 1.8 percent while the
federal funds rate was 4.8 percent.
The current economic environment in the United States
is one of low inflation and inconsistent output growth. To
stimulate output growth, the FOMC has cut the federal
funds rate to a historically low level. In the past, when inflation was high, such an expansionary monetary policy would
have focused attention on the risk of an increase in inflation.
Disinflation would not have been viewed as a potential
problem. Yet, today’s low inflation rate has some different
implications for policy. With the inflation rate as low as it
is now, the risk of sustained deflation cannot be discounted,
especially because disinflation now would yield little offsetting benefit. In this environment of near price stability,
inflation risks are symmetric—one must be wary not only
of shocks that lead to inflation, but also of events that could
create deflation. ■

Federal Funds Rate





Views expressed do not necessarily reflect official positions of the Federal Reserve System.