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For release on delivery
12:30 p.m. EST
November 21, 2002
Deflation: Making Sure "It" Doesn't Happen Here
Remarks by
Ben S. Bemanke
Member, Board of Governors of the Federal Reserve System
Before the
National Economists Club
Washington, D.C.
November 21, 2002
Since World War II, inflation--the apparently inexorable rise in the prices of
goods and services--has been the bane of central bankers. Economists of various stripes
have argued that inflation is the inevitable result of (pick your favorite) the abandonment
of metallic monetary standards, a lack of fiscal discipline, shocks to the price of oil and
other commodities, struggles over the distribution of income, excessive money creation,
self-confirming inflation expectations, an "inflation bias" in the policies of central banks,
and still others. Despite widespread "inflation pessimism," however, during the 1980s
and 1990s most industrial-country central banks were able to cage, if not entirely tame,
the inflation dragon. Although a number of factors converged to make this happy
outcome possible, an essential element was the heightened understanding by central
bankers and, equally as important, by political leaders and the public at large of the very
high costs of allowing the economy to stray too far from price stability.
With inflation rates now quite low in the United States, however, some have
expressed concern that we may soon face a new problem--the danger of deflation, or
falling prices. That this concern is not purely hypothetical is brought home to us
whenever we read newspaper reports about Japan, where what seems to be a relatively
moderate deflation--a decline in consumer prices of about 1 percent per year--has been
associated with years of painfully slow growth, rising joblessness, and apparently
intractable financial problems in the banking and corporate sectors. While it is difficult
to sort out cause from effect, the consensus view is that deflation has been an important
negative factor in the Japanese slump.
-2So, is deflation a threat to the economic health of the United States? Not to leave
you in suspense, I believe that the chance of significant deflation in the United States in
the foreseeable future is ext*emely small, for two principal reasons. The first is the
resilience and structural staijility ofthe U.S. economy itself. Over the years, the U.S.
economy has shown a remmtkable ability to absorb shocks of all kinds, to recover, and to
continue to grow. Flexible and efficient markets for labor and capital, an entrepreneurial
tradition, and a general willingness to tolerate and even embrace technological and
economic change all contribute to this resiliency. A particularly important protective
factor in the current enviro~ent is the strength of our financial system: Despite the
adverse shocks of the past y¢ar, our banking system remains healthy and well-regulated,
and firm and household balance sheets are for the most part in good shape. Also helpful
is that inflation has recently been not only low but quite stable, with one result being that
inflation expectations seem well anchored. For example, according to the University of
Michigan survey that underlies the index of consumer sentiment, the median expected
rate of inflation during the next five to ten years among those interviewed was 2.9 percent
in October 2002, as compar~d with 2.7 percent a year earlier and 3.0 percent two years
earlier--a stable record indeed.
,
The second bulwark Mainst deflation in the United States, and the one that will be
the focus of my remarks tod~y, is the Federal Reserve System itself. The Congress has
given the Fed the responsibilhy of preserving price stability (among other objectives),
which most definitely implie~ avoiding deflation as well as inflation. I am confident that
the Fed would take whatever: means necessary to prevent significant deflation in the
United States and, moreoved that the U.S. central bank, in cooperation with other parts of
-3the government as needed, has sufficient policy instruments to ensure that any deflation
that might occur would be both mild and brief.
Of course, we must take care lest confidence become over-confidence.
Deflationary episodes are rare, and generalization about them is difficult. Indeed, a
recent Federal Reserve study of the Japanese experience concluded that the deflation
there was almost entirely unexpected, by both foreign and Japanese observers alike
(Aheame et aI., 2002). So, having said that deflation in the United States is highly
unlikely, I would be imprudent to rule out the possibility altogether. Accordingly, I want
to tum to a further exploration of the causes of deflation, its economic effects, and the
policy instruments that can be deployed against it. Before going further I should say that
my comments today reflect my own views only and are not necessarily those of my
colleagues on the Board of Governors or the Federal Open Market Committee.
Deflation: Its Causes and Effects
Deflation is defined as a general decline in prices, with emphasis on the word
"general." At any given time, especially in a low-inflation economy like that of our
recent experience, prices of some goods and services will be falling. Price declines in a
specific sector may occur because productivity is rising and costs are falling more
quickly in that sector than elsewhere or because the demand for the output of that sector
is weak relative to the demand for other goods and services. Sector-specific price
declines, uncomfortable as they may be for producers in that sector, are generally not a
problem for the economy as a whole and do not constitute deflation. Deflation per se
occurs only when price declines are so widespread that broad-based indexes of prices,
such as the consumer price index, register ongoing declines.
-4-
The sources of deflation are not a mystery. Deflation is in almost all cases a side
effect of a collapse of aggre&ate demand--a drop in spending so severe that producers
must cut prices on an ongoing basis in order to find buyers. 1 Likewise, the economic
effects of a deflationary epis~de, for the most part, are similar to those of any other sharp
decline in aggregate spending--namely, recession, rising unemployment, and financial
stress.
However, a deflationary recession may differ in one respect from ''normal''
recessions in which the inflation rate is at least modestly positive: Deflation of sufficient
magnitude may result in the nominal interest rate declining to zero or very close to zero. 2
Once the nominal interest rate is at zero, no further downward adjustment in the rate can
occur, since lenders generally will not accept a negative nominal interest rate when it is
possible instead to hold cash. At this point, the nominal interest rate is said to have hit
the "zero bound."
Deflation great enouWt to bring the nominal interest rate close to zero poses
special problems for the economy and for policy. First, when the nominal interest rate
has been reduced to zero, thei real interest rate paid by borrowers equals the expected
rate of deflation, however large that may be. 3 To take what might seem like an extreme
example (though in fact it oc~urred in the United States in the early 1930s), suppose that
I Conceivably, deflation could also l be caused by a sudden, large expansion in aggregate supply arising, for
example, from rapid gains in prod~ctivity and broadly declining costs. I don't know of any unambiguous
example of a supply-side deflation, although China in recent years is a possible case. Note that a supplyside deflation would be associated with an economic boom rather than a recession.
2 The nonunal mterest rate is the sum of the real interest rate and expected inflation. If expected inflation
moves with actual inflation, and the real interest rate is not too variable, then the nominal interest rate
declines when inflation declines--an effect known as the Fisher effect, after the early twentieth-century
economist Irvmg Fisher. If the ratt! of deflation is equal to or greater than the real interest rate, the Fisher
effect predicts that the nominal mt<)rest rate wlII equal zero.
3 The real interest rate equals the n~minal interest rate minus the expected rate of inflation (see the previous
footnote). The real mterest rate measures the real (that is, mflatlOn-adjusted) cost ofborrowmg or lending.
- 5deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a
year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the
loan must be repaid in dollars whose purchasing power is 10 percent greater than that of
the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost
of borrowing becomes prohibitive. Capital investment, purchases of new homes, and
other types of spending decline accordingly, worsening the economic downturn.
Although deflation and the zero bound on nominal interest rates create a
significant problem for those seeking to borrow, they impose an even greater burden on
households and firms that had accumulated substantial debt before the onset of the
deflation. This burden arises because, even if debtors are able to refinance their existing
obligations at low nominal interest rates, with prices falling they must still repay the
principal in dollars of increasing (perhaps rapidly increasing) real value. When William
Jennings Bryan made his famous "cross of gold" speech in his 1896 presidential
campaign, he was speaking on behalf of heavily mortgaged farmers whose debt burdens
were growing ever larger in real terms, the result of a sustained deflation that followed
4
America's post-Civil-War return to the gold standard. The financial distress of debtors
can, in tum, increase the fragility of the nation's financial system--for example, by
leading to a rapid increase in the share of bank loans that are delinquent or in default.
Japan in recent years has certainly faced the problem of"debt-deflation"--the deflationinduced, ever-increasing real value of debts. Closer to home, massive financial problems,
including defaults, bankruptcies, and bank failures, were endemic in America's worst
Throughout the latter part of the nineteenth century, a worldwide gold shortage was forcing down prices
in all countries tied to the gold standard. Ironically, however, by the time that Bryan made his famous
speech, a new cyanide-based method for extracting gold from ore had greatly increased world gold
supplies, ending the deflationary pressure.
4
-6encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the
u.s. price level fell about 10 percent per year.
Beyond its adverse effects in financial markets and on borrowers, the zero bound
on the nominal interest rate raises another concern--the limitation that it places on
conventional monetary policy. Under normal conditions, the Fed and most other central
banks implement policy by setting a target for a short-term interest rate--the overnight
federal funds rate in the United States--and enforcing that target by buying and selling
securities in open capital markets. When the short-term interest rate hits zero, the central
bank can no longer ease policy by lowering its usual interest-rate target. 5
Because central banks conventionally conduct monetary policy by manipUlating
the short-term nominal interest rate, some observers have concluded that when that key
rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no
longer has the power to expand aggregate demand and hence economic activity. It is true
that once the policy rate has been driven down to zero, a central bank can no longer use
its traditional means of stimulating aggregate demand and thus will be operating in less
familiar territory. The central bank's inability to use its traditional methods may
complicate the policymaking process and introduce uncertainty in the size and timing of
the economy's response to policy actions. Hence I agree that the situation is one to be
avoided if possible.
However, a principal message of my talk today is that a central bank whose
accustomed policy rate has been forced down to zero has most definitely not run out of
A rather different, but historically important, problem associated with the zero bound is the possibility
that policymakers may mistakenly interpret the zero nominal interest rate as signaling conditIOns of "easy
money." The Federal Reserve apparently made this error in the 1930s. In fact, when prices are falling, the
real interest rate may be high and monetary policy tight, despite a nominal interest rate at or near zero.
5
-7ammunition. As I will discuss, a central bank, either alone or in cooperation with other
parts of the government, retains considerable power to expand aggregate demand and
economic activity even when its accustomed policy rate is at zero. In the remainder of
my talk, I will first discuss measures for preventing deflation--the preferable option if
feasible. I will then tum to policy measures that the Fed and other government
authorities can take if prevention efforts fail and deflation appears to be gaining a
foothold in the economy.
Preventing Deflation
As I have already emphasized, deflation is generally the result of low and falling
aggregate demand. The basic prescription for preventing deflation is therefore
straightforward, at least in principle: Use monetary and fiscal policy as needed to support
aggregate spending, in a manner as nearly consistent as possible with full utilization of
economic resources and low and stable inflation. In other words, the best way to get out
of trouble is not to get into it in the first place. Beyond this commonsense injunction,
however, there are several measures that the Fed (or any central bank) can take to reduce
the risk of falling into deflation.
First, the Fed should try to preserve a buffer zone for the inflation rate, that is,
during normal times it should not try to push inflation down all the way to zero.6 Most
central banks seem to understand the need for a buffer zone. For example, central banks
with explicit inflation targets almost invariably set their target for inflation above zero,
generally between I and 3 percent per year. Maintaining an inflation buffer zone reduces
Several studies have concluded that the measured rate of inflation overstates the "true" rate of inflation,
because of several biases in standard price indexes that are difficult to eliminate in practice. The upward
bias in the measurement of true inflation is another reason to aim for a measured inflation rate above zero.
6
-8the risk that a large, unantiCipated drop in aggregate demand will drive the economy far
enough into deflationary tetritory to lower the nominal interest rate to zero. Of course,
this benefit of having a buffer zone for inflation must be weighed against the costs
associated with allowing a higher inflation rate in normal times.
Second, the Fed should take most seriously--as of course it does--its responsibility
to ensure financial stability iin the economy. Irving Fisher (1933) was perhaps the first
economist to emphasize the: potential connections between violent financial crises, which
lead to "fire sales" of assets! and falling asset prices, with general declines in aggregate
demand and the price level.:
A healthy, well capitalized \>anking system and smoothly functioning capital markets are
an important line of defense against deflationary shocks. The Fed should and does use its
regulatory and supervisory powers to ensure that the financial system will remain
I
resilient if financial conditiQns change rapidly. And at times of extreme threat to
financial stability, the
Fede~al
Reserve stands ready to use the discount window and other
tools to protect the financial! system, as it did during the 1987 stock market crash and the
September 11, 2001, terrori$t attacks.
Third, as suggested \j)y a number of studies, when inflation is already low and the
fundamentals of the econ0n1Y suddenly deteriorate, the central bank should act more
preemptively and more aggressively than usual in cutting rates (Orphanides and Wieland,
2000; Reifschneider and Wi~liams, 2000; Ahearne et aI., 2002). By moving decisively
and early, the Fed may be
a~le
to prevent the economy from slipping into deflation, with
the special problems that entails.
-9As I have indicated, I believe that the combination of strong economic
fundamentals and policymakers that are attentive to downside as well as upside risks to
inflation make significant deflation in the United States in the foreseeable future quite
unlikely. But suppose that, despite all precautions, deflation were to take hold in the U.S.
economy and, moreover, that the Fed's policy instrument--the federal funds rate--were to
fall to zero. What then? In the remainder of my talk I will discuss some possible options
for stopping a deflation once it has gotten under way. I should emphasize that my
comments on this topic are necessarily speculative, as the modem Federal Reserve has
never faced this situation nor has it pre-committed itself fonnally to any specific course
of action should deflation arise. Furthennore, the specific responses the Fed would
undertake would presumably depend on a number of factors, including its assessment of
the whole range of risks to the economy and any complementary policies being
undertaken by other parts of the U.S. government. 7
Curing Deflation
Let me start with some general observations about monetary policy at the zero
bound, sweeping under the rug for the moment some technical and operational issues.
As I have mentioned, some observers have concluded that when the central
bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability
to further stimulate aggregate demand and the economy. At a broad conceptual level, and
in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat
(that is, paper) money system, a government (in practice, the central bank in cooperation
7 See Clouse et al. (2000) for a more detailed diSCUSSIOn of monetary policy options when the nonunal
short-term interest rate IS zero.
- 10 with other agencies) should always be able to generate increased nominal spending and
inflation, even when the short-term nominal interest rate is at zero.
The conclusion that deflation is always reversible under a fiat money system
follows from basic economic reasoning. A little parable may prove useful: Today an
ounce of gold sells for $300! more or less. Now suppose that a modem alchemist solves
his subject's oldest problem'by finding a way to produce unlimited amounts of new gold
at essentially no cost. Moreover, his invention is widely publicized and scientifically
verified, and he announces his intention to begin massive production of gold within days.
What would happen to the price of gold? Presumably, the potentially unlimited supply of
cheap gold would cause the market price of gold to plummet. Indeed, if the market for
gold is to any degree efficient, the price of gold would collapse immediately after the
announcement of the invention, before the alchemist had produced and marketed a single
ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value
only to the extent that they are strictly limited in supply. But the U.S. government has a
technology, called a printing I press (or, today, its electronic equivalent), that allows it to
produce as many U.S. dollars as it wishes at essentially no cost. By increasing the
number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S.
government can also reduce the value of a dollar in terms of goods and services, which is
equivalent to raising the prices in dollars of those goods and services. We conclude that,
under a paper-money system, a determined government can always generate higher
spending and hence positive inflation.
- 11 Of course, the U.S. governinent is not going to print money and distribute it willynilly (although as we will see later, there are practical policies that approximate this
behavior). 8 Normally, money is injected into the economy through asset purchases by the
Federal Reserve. To stimulate aggregate spending when short-term interest rates have
reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand
the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting
money into the system--for example, by making low-interest-rate loans to banks or
cooperating with the fiscal authorities. Each method of adding money to the economy
has advantages and drawbacks, both technical and economic. One important concern in
practice is that calibrating the economic effects of nonstandard means of injecting money
may be difficult, given our relative lack of experience with such policies. Thus, as I have
stressed already, prevention of deflation remains preferable to having to cure it. If we do
fall into deflation, however, we can take comfort that the logic of the printing press
example must assert itself, and sufficient injections of money will ultimately always
reverse a deflation.
So what then might the Fed do if its target interest rate, the overnight federal
funds rate, fell to zero? One relatively straightforward extension of current procedures
would be to try to stimulate spending by lowering rates further out along the Treasury
term structure--that is, rates on government bonds of longer maturities. 9 There are at
least two ways of bringing down longer-term rates, which are complementary and could
be employed separately or in combination. One approach, similar to an action taken in
Keynes, however, once semi-seriously proposed, as an anti-deflationary measure, that the government fill
bottles with currency and bury them in nune shafts to be dug up by the public.
9 Because the term structure is normally upward sloping, especially durmg periods of economic weakness,
longer-term rates could be significantly above zero even when the overnight rate IS at the zero bound.
8
- 12 -
the past couple of years by the Bank of Japan, would be for the Fed to commit to holding
the overnight rate at zero for some specified period. Because long-term interest rates
represent averages of current and expected future short-term rates, plus a term premium,
a commitment to keep short-term rates at zero for some time--if it were credible--would
induce a decline in longer-term rates. A more direct method, which I personally prefer,
would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity
Treasury debt (say, bonds maturing within the next two years). The Fed could enforce
these interest-rate ceilings by committing to make unlimited purchases of securities up to
two years from maturity at prices consistent with the targeted yields. Ifthis program
were successful, not only would yields on medium-term Treasury securities fall, but
(because oflinks operating through expectations of future interest rates) yields on longerterm public and private debt (such as mortgages) would likely fall as well.
Lower rates over the maturity spectrum of public and private securities should
strengthen aggregate demand in the usual ways and thus help to end deflation. Of course,
if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also
attempt to cap yields of Treasury securities at still longer maturities, say three to six
years. Yet another option would be for the Fed to use its existing authority to operate in
the markets for agency debt (for example, mortgage-backed securities issued by Ginnie
Mae, the Government National Mortgage Association).
Historical experience tends to support the proposition that a sufficiently
determined Fed can peg or cap Treasury bond prices and yields at other than the shortest
maturities. The most striking episode of bond-price pegging occurred during the years
- 13 -
before the Federal Reserve-Treasury Accord of 1951. 10 Prior to that agreement, which
freed the Fed from its responsibility to fix yields on government debt, the Fed maintained
a ceiling of 2-112 percent on long-term Treasury bonds for nearly a decade. Moreover, it
simultaneously established a ceiling on the twelve-month Treasury certificate of between
7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of3/8 percent
on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite
a level of outstanding government debt (relative to GDP) significantly greater than we
have today, as well as inflation rates substantially more variable. At times, in order to
enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day
bills. Interestingly, though, the Fed enforced the 2-112 percent ceiling on long-term bond
yields for nearly a decade without ever holding a substantial share of long-maturity bonds
outstanding. II For example, the Fed held 7.0 percent of outstanding Treasury securities
in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of
90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of
outstanding Treasury debt.
To repeat, I suspect that operating on rates on longer-term Treasuries would
provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If
See Hetzel and Leach (2001) for a fascinating account of the events leading to the Accord.
See Eichengreen and Garber (1991) and Toma (1992) for descriptions and analyses of the pre-Accord
period. Both articles conclude that the Fed's commitment to low inflation helped convince investors to
hold long-teon bonds at low rates in the 1940s and 1950s. (A similar dynamic would work in the Fed's
favor today.) The rate-pegging policy finally collapsed because the money creation associated with buying
Treasury securities was generating inflationary pressures. Of course, in a deflationary situation, generating
inflationary pressure is precisely what the policy is trying to accomplish.
An episode apparently less favorable to the view that the Fed can manipulate Treasury yields was
the so-called Operation Twist of the 1960s, during which an attempt was made to raise short-term yields
and lower long-teon yields simultaneously by selling at the short end and buying at the long end.
Academic opinion on the effectiveness of Operation TWIst is diVIded. In any case, this episode was rather
small in scale, did not involve explicit announcement of target rates, and occurred when interest rates were
not close to zero.
10
II
- 14 lowering yields on longer-dated Treasury securities proved insufficient to restart
spending, however, the Fed might next consider attempting to influence directly the
yields on privately issued securities. Unlike some central banks, and barring changes to
current law, the Fed is relatively restricted in its ability to buy private securities directly. 12
However, the Fed does have! broad powers to lend to the private sector indirectly via
banks, through the discount window. 13 Therefore a second policy option, complementary
to operating in the markets for Treasury and agency debt, would be for the Fed to offer
fixed-term loans to banks at low or zero interest, with a wide range of private assets
(including, among others, corporate bonds, commercial paper, bank loans, and
mortgages) deemed eligible as collateral. 14 For example, the Fed might make 90-day or
180-day zero-interest loans tb banks, taking corporate commercial paper of the same
maturity as collateral. Pursued aggressively, such a program could significantly reduce
liquidity and term premiums I on the assets used as collateral. Reductions in these
premiums would lower the cost of capital both to banks and the nonbank private sector,
over and above the beneficia~ effect already conferred by lower interest rates on
government securities. 15
12 The Fed is allowed to buy certa4t short-term private instruments, such as bankers' acceptances, that are
not much used today. It is also peI1Jnitted to make IPC (individual, partnership, and corporation) loans
directly to the private sector, but o~ly under stringent criteria. This latter power has not been used since the
Great Depression but could be inv~ked in an emergency deemed sufficiently serious by the Board of
Governors.
.
13 Effective January 9, 2003, the d~scount window will be restructured into a so-called Lombard facility,
from which well-capitalized banksiwill be able to borrow freely at a rate above the federal funds rate.
These changes have no important ~earing on the present discussion.
14 By statute, the Fed has consider~ble leeway to detennine what assets to accept as collateral.
IS In carrying out normal discount window operations, the Fed absorbs virtually no credit risk because the
borrowing bank remains responsible for repaying the discount window loan even if the issuer of the asset
used as collateral defaults. Hence both the private issuer of the asset and the bank itself would have to fail
nearly simultaneously for the Fed to take a loss. The fact that the Fed bears no credit risk places a limit on
how far down the Fed can drive th¢ cost of capital to private nonbank borrowers. For various reasons the
Fed might well be reluctant to incci" credit risk, as would happen If it bought assets directly from the private
nonbank sector. However, should this additional measure become necessary, the Fed could of course
- 15 The Fed can inject money into the economy in still other ways. For example, the
Fed has the authority to buy foreign government debt, as well as domestic government
debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity
of foreign assets eligible for purchase by the Fed is several times the stock of U.S.
government debt.
16
I need to tread carefully here. Because the economy is a complex and
interconnected system, Fed purchases of the liabilities of foreign governments have the
potential to affect a number of financial markets, including the market for foreign
exchange. In the United States, the Department of the Treasury, not the Federal Reserve,
is the lead agency for making international economic policy, including policy toward the
dollar; and the Secretary of the Treasury has expressed the view that the determination of
the value of the U.S. dollar should be left to free market forces. Moreover, since the
United States is a large, relatively closed economy, manipulating the exchange value of
the dollar would not be a particularly desirable way to fight domestic deflation,
particularly given the range of other options available. Thus, I want to be absolutely
clear that I am today neither forecasting nor recommending any attempt by U.S.
policymakers to target the international value of the dollar.
Although a policy of intervening to affect the exchaflge value ofthe dollar is
nowhere on the horizon today, it's worth noting that there have been times when
exchange rate policy has been an effective weapon against deflation. A striking example
always go to the Congress to ask for the requisite powers to buy private assets. The Fed also has
emergency powers to make loans to the private sector (see footnote 12), which could be brought to bear if
necessary.
16 The Fed has committed to the Congress that it will not use this power to "bailout" foreign governments;
hence in practice it would purchase only hIghly rated foreign government debt.
- 16 from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against
gold in 1933-34, enforced by a program of gold purchases and domestic money creation.
The devaluation and the rapid increase in money supply it permitted ended the U.S.
deflation remarkably quickly. Indeed, consumer price inflation in the United States, year
on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. 17
The economy grew
strongly~
and by the way, 1934 was one of the best years ofthe
century for the stock market If nothing else, the episode illustrates that monetary
actions can have powerful effects on the economy, even when the nominal interest rate is
at or near zero, as was the case at the time of Roosevelt's devaluation.
Fiscal Policy
Each of the policy options I have discussed so far involves the Fed's acting on its
own. In practice, the effectiveness of anti-deflation policy could be significantly
enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax
cut, for example, accommodated by a program of open-market purchases to alleviate any
tendency for interest rates to increase, would almost certainly be an effective stimulant to
consumption and hence to prices. Even if households decided not to increase
consumption but instead re-balanced their portfolios by using their extra cash to acquire
real and financial assets, the resulting increase in asset values would lower the cost of
capital and improve the balance sheet positions of potential borrowers. A moneyfinanced tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop"
ofmoney.18
17 U.S. Bureau of the Census, Historical Statistics of the United States. Colonial Times to 1970,
Washington, D.C.: 1976.
18 A tax cut financed by money creation is the equivalent of a bond-financed tax cut plus an open-market
operation in bonds by the Fed, and so arguably no explIcit coordination is needed. However, a pledge by
- 17 Of course, in lieu of tax cuts or increases in transfers the government could
increase spending on current goods and services or even acquire existing real or financial
assets. If the Treasury issued debt to purchase private assets and the Fed then purchased
an equal amount of Treasury debt with newly created money, the whole operation would
be the economic equivalent of direct open-market operations in private assets.
Japan
The claim that deflation can be ended by sufficiently strong action has no doubt
led you to wonder, if that is the case, why has Japan not ended its deflation? The
Japanese situation is a complex one that I cannot fully discuss today. I will just make two
brief, general points.
First, as you know, Japan's economy faces some significant barriers to growth
besides deflation, including massive financial problems in the banking and corporate
sectors and a large overhang of government debt. Plausibly, private-sector financial
problems have muted the effects of the monetary policies that have been tried in Japan,
even as the heavy overhang of government debt has made Japanese policymakers more
reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998).
Fortunately, the U.S. economy does not share these problems, at least not to anything like
the Fed to keep the Treasury's borrowing costs low, as would be the case under my preferred alternative of
fixing portions of the Treasury yield curve, might increase the willingness of the fiscal authorities to cut
taxes.
Some have argued (on theoretical rather than empirical grounds) that a money-financed tax cut
might not stimulate people to spend more because the public might fear that future tax increases will just
"take back" the money they have received. Eggertson (2002) provides a theoretical analysis showing that,
if government bonds are not indexed to inflation and certain other conditions apply, a money-financed tax
cut will in fact raise spending and inflation. In brief, the reason is that people know that inflation erodes
the real value of the government's debt and, therefore, that it is in the interest of the government to create
some inflation. Hence they will believe the government's promise not to "take back" 10 future taxes the
money distrIbuted by means of the tax cut.
- 18 the same degree, suggesting that anti-deflationary monetary and fiscal policies would be
more potent here than they ~ave been in Japan.
Second, and more i$portant, I believe that, when all is said and done, the failure
to end deflation in Japan do~s not necessarily reflect any technical infeasibility of
achieving that goal. Rather! it is a byproduct of a longstanding political debate about
how best to address Japan's! overall economic problems. As the Japanese certainly
realize, both restoring bank~ and corporations to solvency and implementing significant
I
structural change are neces~ary for Japan's long-run economic health. But in the short
run, comprehensive economic reform will likely impose large costs on many, for
I
example, in the form of unemployment or bankruptcy. As a natural result, politicians,
economists, businesspeoplej and the general public in Japan have sharply disagreed about
competing proposals for ref~rm. In the resulting political deadlock, strong policy actions
are discouraged, and coope*tion among policymakers is difficult to achieve.
In short, Japan's deflation problem is real and serious; but, in my view, political
constraints, rather than a lac~ of policy instruments, explain why its deflation has
persisted for as long as it ha~. Thus, I do not view the Japanese experience as evidence
against the general conclusi~n that U.S. policymakers have the tools they need to prevent,
I
and, if necessary, to cure a deflationary recession in the United States.
Conclusion
Sustained deflation oan be highly destructive to a modem economy and should be
strongly resisted. Fortunate~y, for the foreseeable future, the chances of a serious
deflation in the United
State~ appear remote indeed, in large part because of our
economy's underlying strengths but also because of the determination of the Federal
- 19 Reserve and other U.S. policymakers to act preemptively against deflationary pressures.
Moreover, as I have discussed today, a variety of policy responses are available should
deflation appear to be taking hold. Because some of these alternative policy tools are
relatively less familiar, they may raise practical problems of implementation and of
calibration oftheir likely economic effects. For this reason, as I have emphasized,
prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you
that the Federal Reserve and other economic policymakers would be far from helpless in
the face of deflation, even should the federal funds rate hit its zero bound. 19
19 Some recent academic literature has warned of the possibility of an "uncontrolled deflationary spiral," in
which deflation feeds on itself and becomes inevitably more severe. To the best of my knowledge, none of
these analyses consider feasible policies of the type that I have described today. I have argued here that
these policies would eliminate the possibility of uncontrollable deflatIOn.
- 20REFERENCES
Ahearne, Alan, Joseph GagI1lon, Jane Haltmaier, Steve Kamin, and others, "Preventing
Deflation: Lessons from Japan's Experiences in the 1990s," Board of Governors,
International Finance Discussion Paper No. 729, June 2002.
Clouse, James, Dale HendeJison, Athanasios Orphanides, David Small, and Peter Tinsley,
"Monetary Policy When the i Nominal Short-term Interest Rate Is Zero," Board of
Governors of the Federal R{)serve System, Finance and Economics Discussion Series
No. 2000-51, November 20QO.
Eichengreen, Barry, and Peter M. Garber, "Before the Accord: U.S. Monetary-Financial
Policy, 1945-51," in R. Glenn Hubbard, ed., Financial Markets and Financial Crises,
Chicago: University of Chi¢ago Press for NBER, 1991.
Eggertson, Gauti, "How to Fight Deflation in a Liquidity Trap: Committing to Being
Irresponsible," unpublished paper, International Monetary Fund, October 2002.
Fisher, Irving, "The Debt-Deflation Theory of Great Depressions," Econometrica (March
1933) pp. 337-57.
Hetzel, Robert L. and RalphF. Leach, "The Treasury-Fed Accord: A New Narrative
Account," Federal Reserve Bank of Richmond, Economic Quarterly (Winter 2001)
pp.33-55.
Orphanides, Athanasios and Volker Wieland, "Efficient Monetary Design Near Price
Stability," Journal of the Japanese and International Economies (2000) pp. 327-65.
Posen, Adam S., Restoring Japan's Economic Growth, Washington, D.C.: Institute for
International Economics, 1998.
Reifschneider, David, and Jdhn C. Williams, "Three Lessons for Monetary Policy in a
Low-Inflation Era," Journal of Money, Credit, and Banking (November 2000) Part 2
pp.936-66.
Toma, Mark, "Interest Rate Controls: The United States in the 1940s," Journal of
Economic History (September 1992) pp. 631-50.
@FedFRASER