August 21, 2002
America's Date with Deflation?

America's Date with Deflation?

Two years ago, at the peak of the late-1990s boom, the American economy was slightly overheated. As the unemployment rate fell to four percent and below, inflation began to creep upward, rising by between a quarter and half a percentage point each year. By late 2000 it was very clear that America's GDP was one to two percentage points above potential output--above that level at which aggregate demand balanced aggregate supply, at least in the sense that there was neither upward nor downward pressure on inflation.

Today things are very different. Today, in the summer of 2002, America's level of real GDP is running some two percentage points higher than it was in the summer of 2000. However, underneath is the extremely strong underlying productivity growth trend driven by the very real technological revolutions in data processing and data communications. These technological revolutions have boosted potential output by perhaps seven percent over the past two years. Thus today America's real GDP is not one to two percent above but three to four percent below potential output.

How do we know this? Simply look at the unemployment rate: today America is producing two percent more than it did two years ago, and is doing so with an unemployment rate not of four percent but of six percent. Moreover, the unemployment rate is more likely to rise than to fall in the next year and a half. The consensus forecast is that this year American economic growth will be positive, but will be significantly less than the rate of growth of potential output. Next year, in 2003, the consensus forecast is for American economic growth to be about 3.5% next year--equal to the rate of growth of potential output, but not enough to even begin to close the output gap.

With production substantially below potential output, there is downward pressure on American inflation. We have already seen American inflation drop nearly in half over the past two years. We do not expect this downward pressure to lessen for at least the next year and a half. If you do the math, you conclude that by the summer of 2004 the U.S. will have an inflation rate--at least as measured by the GDP deflator--that is less than zero. The U.S. will, if these forecasts come true, have joined Japan in deflation.

What does this mean? The first implication of deflation is that the central bank's ability to carry out a stimulative and expansionary monetary policy is greatly restricted. When inflation is four percent per year, the central bank can provide businesses with powerful incentives to take their spare cash and use it to build factories and buy equipment: if the central bank pushes short-term interest rates near zero, businesses are faced with the choice between investing in their business or watching the real value of their cash on hand shrink by four percent per year. When there is deflation, the central bank cannot make businesses such offers that they are unlikely to refuse: at a deflation rate of one percent per year, the real value of businesses' cash on hand grows by one percent per year even if the short-term nominal interest rate is as low as it can go.

The consensus forecast for the American economy over the next two years is not a pleasing one. Few (if any) believe that an unemployment rate of 6 percent is necessary to avoid upward pressure on inflation. Almost all are looking forward to a period with a substantial output gap: two years of sub-potential output with unemployment at its current level robs American households of some $800 billion in real production of goods and services.

More important, deflation--even slow deflation, but much more fast deflation--rapidly exposes weaknesses in businesses' and banks' capital structures. If there is the potential for a chain of bankruptcies that will disrupt the flow of funds through financial markets, cripple investment spending, and bring on a deep recession, deflation is the best way to turn that potential into an unpleasant reality.

Most important, however, is that two more years of downward pressure on the rate of inflation will rob the Federal Reserve--America's central bank--of its power to stimulate the economy. Today's GDP-deflator inflation rate is about one percent per year, meaning that today's federal funds rate target of 1.75 percent per year corresponds to a short-term real interest rate of 0.75 percent per year. If the U.S. price level in two years is not rising but falling at one percent per year, then it will be impossible for the Federal Reserve then to pursue a policy as stimulative as the Federal Reserve is pursuing now.

It is in this context that the Federal Reserve's failure to cut interest rates so far this spring and summer is very puzzling. If 1.75 percent was the appropriate interest rate last winter, when stock indices were 20 percent higher than they are today, it is hard to see how 1.75 percent can be the appropriate interest rate today. If 1.75 percent was the appropriate interest rate last winter, before the shock of revelations about corporate accounting began to drive a larger wedge of uncertain size between the terms on which the government can borrow and the terms on which private businesses can raise capital, than 1.75 percent is unlikely to be the appropriate interest rate today. And if the Federal Reserve wishes--as it surely does--to preserve its power to offset and neutralize any future contractionary shocks to the economy that may appear, then the current inflation rate is already dangerously low and already leaves it with remarkably little room for action.

Now none of this means that the American economy is about to run aground. But anyone who has ever sailed a sailboat knows that it is not enough to be far enough away from shore that there is still water under your keel. You have to be able to plot a course that will keep water under your keel. And you have to plot a course that will keep water under your keel even if Mother Nature decides not to cooperate: even if the wind shifts so that you can no longer hold your preferred course, or even if the wind freshens so that your boat is blown sideways more rapidly. The first rule of prudence--in sailboats and in monetary policy-setting committees--is to keep away from situations in which one or even two adverse shocks will cause severe difficulties.

Thus it is disturbing that the consensus forecast seems to paint a picture of the U.S. economy two years hence in which production remains substantially below potential output, and in which slight deflation has taken hold and robbed the Federal Reserve of its power to offset adverse shocks. The current course seems to carry the U.S. economy too close to a lee shore with a potentially freshening wind. It is a course that prudent sailors should not be happy to hold but should be scrambling to change.

J. Bradford DeLong (2002), "America's Date with Deflation," Financial Times (London: August 21, 2002).

Posted by DeLong at August 21, 2002 01:22 AM | Trackback

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Significant typo alert:

"Today things are very different. Today, in the summer of 2002, America's level of real GDP is running some two percentage points higher than it was in the summer of 2002."

I am guessing you mean "than it was in the summer of 2000" but I am not quite sure.

Posted by: David Margolies on August 20, 2002 09:32 PM

Significant typo alert:

"Today things are very different. Today, in the summer of 2002, America's level of real GDP is running some two percentage points higher than it was in the summer of 2002."

I am guessing you mean "than it was in the summer of 2000" but I am not quite sure.

Posted by: David Margolies on August 20, 2002 09:32 PM

Another presumed typo:

"By late 2000 it was very clear that America's GDP was one to two percentage points above potential output--above that level at which aggregate demand balanced aggregate demand"

Posted by: on August 20, 2002 11:37 PM

What about:
Inflation potential from foreigners divesting US investments.
Fiscal stimulus (the Fed has pretty much played its hand).

Posted by: NE Wenglin on August 21, 2002 06:38 AM

Thanks for news about the typos...

Posted by: Brad DeLong on August 21, 2002 07:16 AM

Could foreigners dumping their dollar-denominated assets create noticeable amounts of inflation? That's an interesting question, with no clear answer as of yet...

And I'm pessimistic about Karl Rove as a macroeconomic manager, so I don't think that much can be hoped for from the fiscal-policy side.

Posted by: Brad DeLong on August 21, 2002 07:18 AM

Deflation would rob the Fed of the capability to stimulate the economy via reducing the Fed funds rate, since that can't go below zero. However, (if I still remember my macroeconomics correctly) the Fed could still engage in open market operations to increase the money supply and push up inflation, right?

In general, econ textbooks talk about open market operations and the Fed funds rate as the two tools that the Fed has in manipulating the economy.Yet almost all media coverage focuses on the Fed funds rate. Why is that?

Posted by: RC on August 21, 2002 07:56 AM

I have doubts about the productivity projections/figures. Certainly, if people work fewer hours (as has been reported)and the economy is growing, we must assume strong productivity growth.

That may be the case this moment, but can we keep it up? Are we no piling work onto already busy people? The BusinessWeek TV show reported on that phenomenon. Around our office I have heard people say not too long ago "they just don't have overtime available for me". That may not have been correct even then, but employers may simply pressure employees to report fewer hours. How long (if I am right) can we keep this up?

And then again, the productivity figurees may just get revised anyway.

Posted by: Wolf on August 21, 2002 08:09 AM

The discussion of the appropriate policy rate is benchmarked by 1.75% being appropriate last year. But that was a post 9/11 rate. Normally we'd view 1.75 as already incredibly low. If we believe 9/11 had only temporary effects then Fed is already providing huge stimulus.
Also, would further Fed easing move long end of the yield curve very much? I already think anyone getting 4.2% on 10 year treasuries is buying at an insanely low yield. How much lower can it go?
And yes, I need a FT subscription too.

Posted by: kcarey on August 21, 2002 08:09 AM

I have doubts about the productivity projections/figures. True, if people work fewer hours (as has been reported) and the economy is growing, we must assume strong productivity growth.

My experience is (and it is limited to my work) that for some time now people have been given more work to do in the same time. That implies productivity growth, but I wonder if it is sustainable. Can we keep piling the work onto already busy people?

There could also be the phenomenon that employers pressure their employees to report fewer hours. What I have not seen enough explicitly is a number for employment growth (supposedly there were few jobs added, supporting the productivity growth figures).

Then again, the official numbers may get revised.

Posted by: Wolf on August 21, 2002 08:16 AM

SUMMARY

The world continues to discuss the current economic situation. Talk is cheap. We need some real solutions. One is to develop an export market in Africa, another is to give AIDS medication away to help Africa develop a better standard of living. Regardless the approach, there needs to be some serious discussions about "what is the backup plan" when monetary and fiscal policies fail to reverse debt-deflationary pressures in the United States?"

DISCUSSION

I welcome the interesting insight on deflation. The next step is to start coming up with some specific options to mitigate this risk, or deal with what is likely to happen. On both counts I have been very unimpressed–the country continues to debate "whether we're in a depression or debt-deflationary cycle," yet little is done to discuss "what's the backup plan."

The country needs to realize this debt-deflation problem is a transnational problem. No one country has the solution. It is going to take the world countries' leaders getting together at the G7/8 and agreeing, "This is a real issue, and this is what we're going to do about it."

EXPORT MARKET IN AFRICA

Specifically, one proposal would be to develop an export market in Africa. The world leaders at the G7/8 conference could agree, "As a strategy to get the world economy out of this debt-deflationary cycle, we're going to develop Africa from the ground up."

If there is no world agreement to "work together," then the only other catalyst for "mobilizing the economy" is a war. That is unacceptable, yet I fear is part of the motivation driving the Administration to launch another campaign in Iraq: The expected "rebound" in the economy by mobilizing post-9-11 is not achieving the similar benefits as was seen when the US mobilized for War after 1939, and really got going after Dec 7 1941.

Developing an export market in Africa would have many benefits. One strategy would be to put the headquarters of a CEO or a significant leader in the middle of the continent and say, "We're going to create an infrastructure to support this remote location."

If the CEO were sitting in the middle of nowhere, there's be a great incentive to "get the fresh water" to that remote location. I'm talking reverse-osmosis desalinization tanks along the African coast, importing fresh water, and creating a viable agricultural land. Sure, it's expensive. But that's the point: The money gets invested, put to good use, and those living on the African continent can get the fresh water needed to develop their economy. Yes, there are other ways (wells) of getting freshwater, but I'm not saying that "desalinization is the only answer," just one of many options that are not widespread.

At the same time, the world needs to be working with Africa to identify local requirements. Unless Africa is involved in the planning from the ground up, there's no sense in throwing money at the problem. They need to be involved with understanding the importance of internal controls, accounting, and corporate governance. The best that the US could do would be to provide an example. "Do as we do, not just as we say."

FINANCING

Clearly, such a proposal doesn't come out of thin air and someone has to pay for it. One option is to use a reverse swap agreement whereby money is loaned in the form of bonds against the future earnings of Africa. This money is then swapped with the excess capacity and resources in Asia.

The net result of this transaction would be the raw materials would be exchanged at not a sales price, but a transfer which would mean there's not effect on the price or price stability. Asia would get rid of their excess capacity, and the money swapped could be used to pay off the bank loans and help restructure the Japanese banking sector.

MANPOWER

The above scenario is large. Russia and China have people who need income. Why not get the world leadership to put an emphasis on getting Russian and Chinese workers into Africa so they could help develop the infrastructure. I'd rather the world fight over contracts than fight over land in a land war.

Bluntly, it should be well understood that the Russian and Chinese workers would be sending quite a bit of money back to their homelands, and that's the purpose. This debt-deflation is worldwide, and Russia and China also need to be part of the solution. Where does Europe and the US fit in? With the management and planning.

AIDS MEDICATION FOR AFRICAN CONSUMERS

Another approach is for the US to buy up AIDS-medicine from the corporations (at market prices) and then give the AIDS medication away in exchange for favorable trade agreements. This would show the Congress "the President can achieve fast track results with fast track authority."

AIDS medication means African consumers will be around longer, and corporations will be able to have sales, revenues, and taxable income. As a result of these favorable trade agreements, the US government will get increased tax revenues.

Clearly, for such a proposal to "pass the sanity test," we'd need some data on "how much would corporate tax revenues increase with the increased trade with Africa after the desalinization project and AIDS medication. I suspect that the relatively small "give away program today" would have high returns. Although the US government might get tagged with a large bill for the AIDS medication, the increased tax revenues would offset this initial investment.

SUMMARY

Leadership is about moving forward. I see plenty of people arguing over the past. That is counter productive. Let's start figuring out a realistic plan to move forward.

The world has taken many years after the 1989 bubble popped in Japan to realize that we are in a post-war debt-deflationary cycle. It is welcome news to have economists talk about the economic problems. We need to encourage these insightful economists to start developing some robust risk mitigation and solutions to this problem.

A transnational approach is needed. We do not need the catalyst of a financial crisis and a war to wake the world up. The G7/8 is there and can embrace these initiatives. Time is of the essence. If we wait too long, we'll lose the very resources in a financial crisis that we're hoping to save.

Two possible options include a transnational commitment to develop an export market in Africa, and a US decision to give AIDS medication away. Regardless the final approach, I want to start hearing more realistic plans from people on "what are we going to do to mitigate the adverse effects of deflation." The talent is there. We just need a decision to figure out the solution.

Posted by: on August 21, 2002 10:54 AM

Since the danger of deflation has been clearly and compellingly described, why is it that the Fed governors seem to have dismissed the prospect? What model is the Fed adopting that allows the prospect of slow GDP anf employment growth and the possibility of deflation to be entertained?

Is there worry about further inflating the housing market? Further accelerating automobile purchases? Could the absolute federal funds level of 1.75% be considered a problem? "Running out of room to lower?" Surely not money supply growth?

I am puzzled and worried. The economic and stock market declines have a different quality than declines since WWII. The economic decline smacks of the type of insufficient demand that appeared to characterize much older business cycles. The Fed appears to find the economic and market declines typical of recent cycles and is prepared for steady if slow progress to recovery.

Tricky situation.

Posted by: on August 21, 2002 11:59 AM

That we're in a housing "bubble" is of little debate. For instance I live in downtown Chicago, where it is 30 to 40 percent cheaper per month to rent than to buy and the city is about to double its downtown housing stock in the next two years.

I have also read about similar situations in other cities across the country.

The bottom line here is the Fed is in a tricky situation. If it lowers interest rates further, it could encourage even more housing speculation, prolonging the bubble and causing more long-term damage. If it raises the rates, it could prick the housing bubble now, but also damage the rest of the economy.

So, it decides to leave the rates where they are. Not the greatest solution, but possibly the only one available at the moment.

Posted by: Rich Miller on August 21, 2002 01:59 PM

Note: Links are in gold

A bubble is not inflationary; but a stock crash is both a symptom and cause of deflationary pressures. Study on housing bubble; falling RE prices are possible, and reduced wealth impacts spending, thereby further fueling deflationary pressure.

Here are some other views on the causes, risks associated with deflation. Of concern, the Fed has run out of options.

Posted by: on August 21, 2002 02:33 PM

Krugman does a good job of explaining why why the delfation fears are low [Ref(NYT) Op-Ed, August 16, 2002 "Mind the Gap" By PAUL KRUGMAN ] All the factors that "make the US different" are no longer valid.

Fed discussion on deflation The Fed is watching deflation in Japan, but seems to believe the US is immune. Not clear to me "just because we understand Japan" that we are immune to Japan's ailment. Understanding a problem is much different than solving the problem.

Posted by: on August 21, 2002 02:49 PM

Bravo! for the sailing analogy. It's a handy analogy for most policy discussions we're currently having. The spirit of the times is to fix everything ex-post with a mix of lipservice and fiscal incontinence...

Re: deflation, I was wondering was will be the effect of the War on prices. (I am resigned, however stupid a move I think it would be. Why? Street Americans are blood thirsty, a prediction even my neighbours had made the day after 9/11).

Prices will increase as a result of the War, and possibly employment as well, although not in the sectors we would like to expand (okay, that can be considered a politically tainted statement...) Why worry about that? Because it's not like Japan has not tried using public spending to close the gap!

We shouldn't have gotten here in the first place. But then, do we need getting even closer to those rocks? How about a 21st Century New Deal (you want to give the money to _consumers_ in our kind of circumstances) and a joyful drive towards global economic integration? As you can see, I like Sci-Fi too...

P.S. I just stumbeld across this http://newdeal.feri.org/

Posted by: Jean-Philippe Stijns on August 21, 2002 05:22 PM

Professor DeLong,
You and Krugman seem to agree in that the US economic growth rate (about 3.5% next year) will not be enough to close output gap. while I agree with you that such cast will bring deflation risk, don't you think it is a littel dangerous to draw such conclusion based on two years of data on unemployment?

Posted by: Jo Kim on August 22, 2002 01:16 AM

Should the Fed worry about a further increase in housing prices rather than continue to lower the federal funds rate to further stimulate growth?

My sense is that the Fed should not worry about asset prices at the expense of economic growth. The risk of deflation is greater than the risk of further property prices increases.

Posted by: on August 22, 2002 10:01 AM

What about salaries and deflation. Alot of salaries are negotiated and with wages going up. might that hinder deflation?

Posted by: on August 24, 2002 10:13 AM

Employees seem to have relatively little ability to negotiate meaningful wage increases at present. One area in which price increases are presently seen is health care, especially the prices for drugs. There are other areas in which prices have been increasing recently. Insurance and steel for example. But, the overall risk seems to be deflationary.

Posted by: on August 24, 2002 02:01 PM

In March of 2001 I wrote you to inquire about the possibility of the US economy becoming deflationary. Your reply was essentially that the US didn't need to worry about deflation and that the Japanese experience was unique. I must admit that at the time I didn't find your answer very convincing and continued to warn my students about the possibilities of deflation, which I continue to do. I'm glad you have finally seen that a deflationary cycle is certainly possible and may already have started. My own solution, although admittedly simplistic due to space considerations, is anethema to the class-driven policies of the last 20+ years since I would advocate a massive redistribution of income to those making under 25,000 because those millions of people have a large amount of unfulfilled demand, whereas the other classes are already tapped out demand wise. Of course, politically this is unlikely to happen. So, we can look forward to the depression I've been predicting for the last two semesters. And Bush is enough of a fool to go to war, which is all the push the economy needs to go over the edge.

Posted by: Karl Sanchez on August 29, 2002 12:06 AM

The "deflationary cycle" if it appears in the US, will be dependent on the ever growing current account deficit, which depends in turn on the continued transfer of manufacturing capacity off shore, which is itself dependent on various methods of distorting the value of third world labor, usually by corrupt aristocracies who are far more interested in purchasing real property and corporations in US dollars than in paying their workers a decent wage.
Even a small change in trade policy that had the affect of lowering the US current account deficit would be very likely to shift the inflationary curve into positive territory, since it would put pressure on US manufacturing to grow at a less anemic rate while increasing the cost of the imports on which the deflation is dependent.
The use of a tarrif rate that is adjustable in small increments as a tool to manage at least the growth and direction of the kinds of distortionary trade deficits the US has experienced in the last decade would, of course, be politically difficult to get into the WTO process, and even harder for some economists to take seriously as a response to this continuing problem.
Another rhetorical difficulty in the development of such methods is the case of Japan, which illustrates that trade surpluses do not guarentee a lack of deflation. Nevertheless, economic history illustrates that methods which work usually do so because they apply well to the specifics of a situation, and methods which have only short term value usually do because the situations which they effectively address go away more quickly than do the proponents of what have developed into maladapted solutions.
The US current account deficit's distortionary effects do not seem to have had the tendency to go away either soon or on their own. Their endemic nature, however, may provide the opportunity to fashion, with the proper academic work and international negotiations (and much gnashing of teeth) a small set of effective macroeconomic tools. The key criteria, however, would have to be their limited nature, lack of international discrimination (i.e. focus on the overall domestic or broadly measured world economy as their target), and their gradual application in small steps with appropriate consideration of the time delay involved in their economic effects.
In other words, you find the leverage where the leverage is, not necessarily where it used to be. (As the joke goes, when the people have nothing, Say's law applies pretty darn well; Under other conditions, you just have to advertise and hope for the best.)
I would not advocate this method for all nations under all conditions, since few (if any?) nations consistently report the level of current account deficits that the US "suffers". It may need, however, in cases such as this, to become a principle of the WTO that some soverignty should remain in the case of a member who is being subject to a clear long term trade distortion, which would allow the affected country to develop macroeconomic tools to systematically and legally manage the situation in order to prevent the cumulative damage that such continuing distortions unfortunately create from becoming economically overwhelming. The difficult and enduring crises that such cumulative problems can create are worth addressing systematically, and if cleverly addressed with fair and effective (rather than theoretically perfect) macroeconomic tools, then all the participants of the WTO system can benefit from a more stable and sustainable trading system.
Ok, now you can start screaming ;)

Posted by: BC Price on September 11, 2002 03:26 AM

Money has been dumped in Africa before, it's hard to develop when the people have scientifically proven smaller brain sizes and average IQ's of 70 pts. They just can't grasp concepts as Europeans or Asians can. It has been tried.

They would have to be supervised by Europeans or Asians, then assimulation would occur. If you have a even mix of African & European or Asian you'll have a 85 Iq population. You can't fight genetics, you can't fight assimulation,

Then there's the problem with over population and too few resources, the US alone consumes over 70% of the worlds resources.

The world's oceans are being fished out, don't be surprised that shark will become a delicacy. Tough as it is.

There's not enough to go around for everyone to be on our economic level.

Capitalism requires fresh new markets to survive, there isn't any left. Bringing up 70 IQ Africans would require a genetic change to a Africans mother birth canal, to produce bigger brained babies.

Yes I sound wacked, but I am a genius level IQ and no I'm not KKK or other hate minded. I state facts.

Many talk a good story in their field and easily dismiss seemly wild ideas, but you can't teach people concepts if they don't have the capacity to reason and learn. To innovate, create and motivate.

Posted by: dsfgdg on May 23, 2003 07:29 PM

Money has been dumped in Africa before, it's hard to develop when the people have scientifically proven smaller brain sizes and average IQ's of 70 pts. They just can't grasp concepts as Europeans or Asians can. It has been tried.

They would have to be supervised by Europeans or Asians, then assimulation would occur. If you have a even mix of African & European or Asian you'll have a 85 Iq population. You can't fight genetics, you can't fight assimulation,

Then there's the problem with over population and too few resources, the US alone consumes over 70% of the worlds resources.

The world's oceans are being fished out, don't be surprised that shark will become a delicacy. Tough as it is.

There's not enough to go around for everyone to be on our economic level.

Capitalism requires fresh new markets to survive, there isn't any left. Bringing up 70 IQ Africans would require a genetic change to a Africans mother birth canal, to produce bigger brained babies.

Yes I sound wacked, but I am a genius level IQ and no I'm not KKK or other hate minded. I state facts.

Many talk a good story in their field and easily dismiss seemly wild ideas, but you can't teach people concepts if they don't have the capacity to reason and learn. To innovate, create and motivate.

Posted by: dfgdfgfd on May 23, 2003 07:30 PM
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