September 18, 2002

Paul Krugman forwards an interesting piece on current thinking within the Federal Reserve. The most interesting part is that the Fed--or at least some within the Fed--do not believe that it is running out of room to affect the economy. According to the report, ":...Fed officials are discussing the means they could use -- if it becomes necessary -- to shock American markets into an modest inflationary psychology from the depths of deflation thinking... the implication is... the Fed would rapidly begin to use other monetary policy tools at its disposal. "We do not have a zero bound problem except at the federal funds frontier," one official said, "and the Fed is perfectly capable of operating all along the yield curve. We can expand our balance sheet and buy all down the curve." Of course. And as another official put it, "we are looking at the Federal Reserve Act again to see what our options are. They are actually quite powerful. "

MEDLEY GLOBAL ADVISORS: G7 Special Report: Fed: When Is 3% Growth Not Enough? When There's Deflation

September 13, 2002

If you want to know why Ben Bernanke got a seat around the Federal Reserve table despite widely advocating inflation targeting, then you need to go back to a paper he wrote for the Fed's Jackson Hole conference in 1999. In that paper, Bernanke laid out a powerful argument that central bank officials need to respond to burst bubbles with extremely aggressive, front-loaded interest rate cuts. Both Fed Chairman Greenspan and his powerful right-hand man Don Kohn understood and agreed with the Bernanke thesis immediately. Of course, that became Fed policy in 2001 and now Greenspan, Kohn and Bernanke are all sitting around the FOMC table together.

But there was more to the Bernanke paper than just rate cutting. The central genius of his work was that central bank officials had to pre-empt the development of a deflationary psychology among investors, corporate leaders and consumers. Fast, front-loaded rate cuts are the first step of that response, but if they do not work then a further round of aggressive action has to be taken. In the past few weeks Fed officials have spent an increasing amount of time worrying about the disinflationary forces that are gathering steam. They do not believe the US is in deflation yet, and they certainly are not willing to talk about deflation as a policy problem at this point (and definitely not in public), but the "what if" discussion is well under way.

Will a sustained subpar growth add to deflationary pressures? Driving that discussion are a few very powerful facts. Some 60-75 percent of the CPI is now in deflation, with education, housing and medical care the only components showing serious and sustained price rises and the non-financial corporate GDP deflator is already negative (the aggregate GDP deflator is barely above 1% even with these strong components added back in). If anything, the breadth and pace of these declines towards deflation are increasing over the past few months, despite steady and high energy costs, while the hours worked and employment components of third quarter GDP make it clear that even as production increases, corporations are steadily focused on shedding costs to restore profits.

If these deflationary forces persist, then, two questions get talked about with increasing urgency. The first question is whether high subpar growth (like the 3% range of the third quarter) will help the American economy burst out of this downdraft or do you need at least trend growth to prevent the deflationary forces from accelerating? The second question is whether deflationary forces are turning the current federal funds rate of 1.75% into tighter than realized monetary conditions. Those are technical and important points, but the policy action point is far more fundamental: is the United States drifting toward what Fed officials call a "backward induction" point (from a game theory inflection point that rapidly shifts the odds of potential outcomes due to anticipatory action on your opponent's part) where markets, corporate planners and consumers all conclude that deflation is happening and begin to respond accordingly.

Once that deflationary psychology sets in, it is very hard to eradicate (just ask the Japanese) and so Fed officials are discussing the means they could use -- if it becomes necessary -- to shock American markets into an modest inflationary psychology from the depths of deflation thinking. And that's where the Bernanke thinking becomes particularly important: the implication is not just that the Fed would return to sharp, large and aggressive rate cutting on the Federal funds front, it means the Fed would rapidly begin to use other monetary policy tools at its disposal. "We do not have a zero bound problem except at the federal funds frontier," one official said, "and the Fed is perfectly capable of operating all along the yield curve. We can expand our balance sheet and buy all down the curve." Of course. And as another official put it, "we are looking at the Federal Reserve Act again to see what our options are. They are actually quite powerful."

A potentially new policy and theory frontier:

This does not mean the "plunge commission" to save the stock market is convened and in session. But the higher awareness of a deflation risk does mean that active and interesting backroom discussions are underway in case the current whiffs of deflation turn into more powerful forces as the year ends and next year begins. This is a very different kind of thinking from what drove the split opinion within senior Fed circles about the need to ease rates pre-emptively at the August meeting (which we described in detail in Special Reports before that meeting). That was all about immediate threats to positive economic growth in the July/early August maelstrom. These discussions are far more intriguing because they are forging new policy and theory territory -- when do rate cuts and potentially more aggressive action make sense despite modest positive growth.

If the US economy returns to above trend growth in the fourth quarter and first quarter of next year, then these discussions will almost certainly disappear back into the realm of theory. But if deflationary forces continue to accumulate at the pace they have done so far this year and growth remains below par, then the Bernanke options open up wide once more. That would be a very interesting moment in the history of US monetary policy. We will continue to follow this closely for you.

Posted by DeLong at September 18, 2002 02:19 PM | Trackback

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Of course with all this talk of deflation, what do you think of the fact that core prices rose .3% in august?

Posted by: AT on September 18, 2002 04:16 PM

Admitted economic novice here...

I still don’t understand why deflation is bad. The article states that "60-75 percent of the CPI is now in deflation, with education, housing and medical care the only components showing serious and sustained price rises"

Why would it be bad if education, housing and medical care also went down in cost??? Shouldn’t there naturally be a decline in prices as technology and productivity improve? They certainly do in electronics related industries.

The only negative things I can glean about deflation from the article is worries about "psychology" and the ability of the Fed to affect monetary policy.

As I understand it (limited understanding admitted) the basic model of inflation/deflation is that it results from the ratio of the money supply and the velocity of money to the amount of goods and services. So there are at least 3 different causes of deflation. From history it seems that the ones folks are familiar with are the ones when the money supply or the velocity of money falls. But what we may experience in the future is simply the growth in products and product quality (hard to measure) that exceeds the growth in money supply.

While I can certainly see the negative physiological impact of having people stop spending (lower velocity), it is not at all clear that the same psychology would apply to deflation caused by growth in production and technology. Again the electronics and related industries have dealt with this for decades.

As a final note, I think it is interesting that the three industries experiencing inflation are the of the most heavily regulated and government dominated industries in the US.

So what am I missing on the deflation count?

Rob Sperry

Posted by: Robert Sperry on September 18, 2002 04:27 PM

Bernanke got a seat with the Big Boys because he chose on side of an argument? There were NO other economists in America who thought of that, who wrote papers on that?
Krugman wrote a book in 1999 outlining a potential deflationary problem, and ways to solve it. He also had a lot more to add.
Did Greenspan invite Krugman to the table, to chat about economic theories?
Sounds like a cozy ole power network to me.

Posted by: BobH on September 18, 2002 06:56 PM

Yes, the economists are all in the Fed's Pockets. Er, the Fed is in the economists' pocket, rather. Er...

Posted by: Dennis O'Dea on September 18, 2002 08:26 PM

Let's begin by noting that I love this blog, and most everything else DeLong has written. And, Krugman, while a bit monochromatic (or perhaps monomaniacal, even though I agree with his basic point) of late, is no slouch either.

But, as someone who makes a decent living as a mathematical economist, things like the following snippet (due to Krugman, not Delong) drive me crazy

"is the United States drifting toward what Fed officials call a "backward induction" point (from a game theory inflection point that rapidly shifts the odds of potential outcomes due to anticipatory action on your opponent's part"

With a few Econometrica's under my belt, I can actually decode most of the words that are used here. But, I can't stand the sloppy addition of terms like "game theory" and "backward induction" to pseudo-terms like "inflection point." I know what the author might mean, but game theory really does not need the addition of the term "game theory" to stuff like this. We've got enough problems explaining the limitations of the stuff we *can* do without taking the fall on this one!

Posted by: on September 19, 2002 12:45 AM

Out here in money-on-the-table market-land, growing monetary aggregates, soaring property prices, a rising CRB commodity index, war on the horizon and long treasury yields under the old passbook rate, make a deflation bet HERE quite a risky proposition.

Posted by: George Zachar on September 19, 2002 06:11 AM

Wish that the Bank of Japan had bothered to think about such issues all these years.

Posted by: on September 19, 2002 08:30 AM

In response to Robert Sperry, deflation isn't just falling prices. If that was all there was to the thing then you might consider it would be quite nice.

But basically deflation produces a phenomenon a bit like a bad asthma attack. Your vital organs keep functioning OK, but somehow you can't get enough oxygen to clear the lungs properly (maybe this is not the best analogy but the point should be evident). No one can get enough run-up to get lift-off.

Add to this the fact that everyone with debts has growing problems - and remember an awful lot of Americans have just done refinancing in the hope of increased, not decreased, house prices. Add to this again the fact that the falling prices are in part coming from imports, so there's no job creation in it (look at the currently stagnant US job market). And generally people lose confidence in institutions with debt problems and hold more resources in cash - remember the stock market would be out for the count and interest rates near zero - and it is this additional tendency to hold cash that causes a mismatch between supply and demand and hence a growing potential overcapacity that the markets can't clear off.

I'm a little preoccupied about statements like
"We can expand our balance sheet and buy all down the curve." and "we are looking at the Federal Reserve Act again to see what our options are. They are actually quite powerful."

Obviously it's good news that the Fed is taking this seriously, but I hope they're not looking into the possibility of buying equities like the Japanese have just suggested they are going to do.

On this topic, Professor Makoto Saito from Japan has discovered that in fact monetary easing itself can begin to lose impact as an effect similar to a 'black hole' is created whereby the velocity of circulation of money slows down in proportion to the expansion of the money supply, and hence there is no effect on the price level.

Again one of the consequences of cheap money is that many dead-duck firms keep going thus perpetuating the problem. This was the force, I take it of the German contributions at Jacksons Hole. All in all, it ain't easy.

And of course the backward induction problem is real enough, indeed I ask myself, after all the confidence shocks the US public has had over the last 12 months, how exactly will they react to the suggested shock therapy.

My brother likes to point out to me that when the man on the Clapham Omnibus is chatting away about the decisions of the Fed Funds Rate Committee, well something important is happening. We are all painting ourselves into the picture, and of course all this talk of deflation could be just another example of self-fulfilling expectations.

Posted by: Edward Hugh on September 19, 2002 10:34 AM

For every debtor there's a creditor, and why the Fed should think it should, much less can, bail out Americans who have over-extended themselves with home loans is beyond me. What about moral hazard? Doesn't that mean that people will just take on more debt? There's the cute line that oncee was used on the French, who thought reducing the work week to 35 hours would cut unemployment: "reduce it to 0, and cut it even more." Similarly, it's simply bizarre that some economists think that the solution, when so many people are in debt, is to enact policies which would get them into debt even more.

Posted by: Andrew Boucher on September 19, 2002 11:50 AM

Also in response to R. Sperry.

From one novice to another.

Electronics prices generally fall due to lower production costs. Once the costs of R&D and the initial production ramp-up are covered, producers charge less, retailers pay less, customers pay less, etc.

Deflation sucks because the prices drop due to low demand before the manufacturer's inital costs are covered, and therefore giving manufacturers no incentive to produce new products, further lowering demand, on and on in the the abyss.

I mean, if you produce Widget-A, customers hold off buying it because they will be able to buy it at 75% of the current price in 3 mos, all the money you spent developing it are never recouped, you hold off on production, and thus delay developing lower production costs. On the flip side, if you sell Widget-A's at the initial higher cost, cover R&D, lower production costs, you can then sell at the lower price and still make a profit.

That's my story, and I'm sticking to it.

Posted by: BEM on September 19, 2002 12:07 PM

'Similarly, it's simply bizarre that some economists think that the solution, when so many people are in debt, is to enact policies which would get them into debt even more.'

Debt isn't necessarily bad, you know.

Posted by: Jason McCullough on September 19, 2002 01:19 PM


Deflation causes real problems in the labor market. As a practical matter workers will not allow firms to lower their nominal wage. When there is a positive inflation rate a firm can always lower its wage bill by keeping nominal wages fixed or by laying off workers. When deflation sets in the only way for firms to lower labor costs is to lay off workers.

Posted by: KJD on September 19, 2002 02:19 PM

I remember sitting at an NBER meeting at the SF Fed Reserse Bank well before the market took its recent series of dip this year. Friedman was the speaker of honor and he made a pretty convincing argument that we were heading for a scenario that would bear strong resemblance with the Great Depression.

He just over-imposed a plot of the then current stock market with one of those old times. The similarity was scary.

What worries me is that since then things seem to have confirmed his vision. Deflation fits scaringly well with it. And so do calls for war as an economic way out.

It's interesting to notice that a few important things are never mentionned. O'Neil could talk down the dollar (he is pretty good at talking down currencies.) He could also secretely (or not) sell dollars and buy foreign currency (secrecy does seem to be a big moral problem to this administration.)

A weaker dollar would boost American exports, and put the break on imports. It would pull the rug under the feet of neo-protectionists, and would open a credible window of opportunity for WTO negociations.

Mostly, it would help solving some of the deep macro imbalances that are plaging the US economy (and the corresponding worries market participants have.)

The EU would actually be reasonably compliant with this because they won't be able to refrain themselves from enjoying the "glory" of a strong Euro (and its moral boost effect on the EU in general). Further, it would help the EU keep core inflation in check, thus leaving more room for its monetary and fiscal policies.

The problem is that this will be very difficult to engineer at a reasonable cost as long as the price of oil stays this high (thanks to the prospect of a war in the Middle East) given that the EU has in general an even more dependent energetic position than the US...

A paradox here, is that making American equity and bonds cheaper for the Europeans and Japanese to buy may well give the stock market exactly the kind of boost you'd think it needs. After all, if the dollar dips sufficiently, one can only expect it to bounce back. And traders are in the business of buying low and selling high...

I wonder what kind of role nationalistic concerns play in here.

Down with the dollar, long live America!

Posted by: Jean-Philippe Stijns on September 20, 2002 09:37 AM

Stephen Roach also wishes for an ample decline in the value of the dollar. While such a decline would be helpful to us, what would be the effect on Europe or Japan?

The European Central Bank and Bank of Japan show little interest in speeding growth. Slow growth in Europe and Japan will slow further if the dollar declines in value. Though the American economy appears to be growing too slowly it is probably growing faster than Japan or Europe, and so the dollar is not likely to lose value.

Posted by: on September 20, 2002 10:21 AM

The last post above really has it. All three 'major growth engines' are facing the same problem. Japan is already stuck, America is slipping, and Europe (including the UK with its 20% per annum unsustainable property bubble) is coming down fast (with the added difficulty that the problem seems to be taking Europe unawares - see especially Stephen Roach's post today). Japan is openly trying to get the yen down, the US I am sure is doing little to try to prevent the fall of the dollar, and when the ECB finally wakes up to what is going on then there will be pressure to bring the Euro down too.

This is the real repeat of the 1930's, competitive and thus self-defeating devaluations all round, and thus the lack of collaboration and mutual respect that has been all too evident in recent months on all fronts is the real threat to globalisation processes and growth.

Thus I feel that Jean-Phillipe Stijns under-rates the seriousness of the situation, and the problems of go it alone strategies. Maybe inside the US you aren't too aware of this, but your government is not too well placed right now to be demanding tolerance and understanding as you let the dollar fall. So in my book the risks of a continuing relatively high dollar and thus a steady slide into US deflation are not negligable.

One last point for those who still think that deflation might not be a bad thing. Changes in price levels do not affect all income groups equally. Education and health care costs are likely to remain above trend, as are some other basic items in our diets and lifestyles. Those therefore like the old and single parents who do not lean heavily in their lifestlye on technological and information products are going to be adversly affected in terms of their real living standards.

Posted by: Edward Hugh on September 20, 2002 10:55 AM

Edward Hugh has pointed to a most important problem - what seem to be global growth constraints. Where do we find a further growth stimulus - American consumers are taking advantage of low mortgage rates and low interest rates on automobiles. But, employment is a problem and wages are constrained. American businesses have little price flexibility and little need for large investments to increase capacity. America will not spur growth abroad. Slow growth abroad, in turn, will not spur America.

Posted by: on September 20, 2002 12:17 PM

I take good notes of the replies to my posts, they're very thoughtful.

But, let me add in the following:

* the EU can be begged for external growth because it has a lot to munch internally as far as trade is concerned (e.g. Eastern Europe).

* if the EU could set aside concerns about inflationary pressures coming from high oil prices, by paying for them in an appreciated currency, the ECB will probably willing to cut interest rates further.

* I was suggesting to accompany a dollar devaluation with a sincere drive towards credible WTO negotiations. Today, the US position is not credible because of its political concerns for inefficient domestic industries. With a depreciated dollar, the US will aquire room for manoeuver.

* Japan is a concern, but it's not very helpful for American growth anyway, an specifically in regards to fixing American macro-imbalances. It has always acted in a rather selfish way in spite of the generally benevolent attitude of the US towards it.

* I have little compassion for Japan's economic voes (in spite of my personal passion for things Japanese.) They're mostly of its own making and the Japanese governments have for now a decade consistently given in to vested interests instead of cleaning up their banking mess.

The beggar-thy-neighbour concern is serious though, I aggree, and, indeed, also bears resemblance with the 30s. It's not like it's not at work yet though. The steel and agriculture protectionist policies followed by the US do the same job, albeit in a less transparent and even less acceptable way.

In an other world (than Bush'es world), you'd want the US to discuss this issue at a G8 meeting and propose an acceptable and realistic plan of action for the world major economies. I think a serious round of actual WTO negotiations would be a second good step along that way.

And the simple consultation and coordination with American trade partners would go a long way, I think, in restoring the rest of the world's trust in both the seriousness and the benevolence of the Empire. ;-) You know if we only talk to each other (as in "dialog") I already feel that you are paying some kind of respect for me and my positions...

Posted by: Jean-Philippe Stijns on September 20, 2002 01:00 PM

One last point for those who still think that deflation might not be a bad thing. Changes in price levels do not affect all income groups equally.

True. No change in the economy affects all income groups equally. That kind of symmetry is obviously impossible at the scale under discussion.

For those old enough to remember the inflation surge of the '70s, the exact same argument was made, to wit, some specific populations would suffer relatively more than others.

Disproportionate outcomes occur under every imaginable economic scenario in a continent-wide, decentralized, mostly free, economy.

Posted by: George Zachar on September 20, 2002 04:06 PM

"Debt isn't necessarily bad, you know." Economics not being the science of the a priori, there aren't many economic assertions which are necessarily true. So this retort isn't saying much is it? My assertion is not that debt is always bad, but that at the present time most Americans have taken on too much debt. Do you disagree with that?

Posted by: Andrew Boucher on September 22, 2002 08:19 AM

I have no damn idea whether we've taken on too much debt; what's the proper level, and how do you determine it? Some variant of the golden rule for investment?

Posted by: Jason McCullough on September 22, 2002 02:44 PM

By the way, it seems like Stiglitz is thinking like me, lately in the FT. Or is it the other way around? :-)

Posted by: Jean-Philippe Stijns on September 23, 2002 12:31 AM


"Too much debt" is the battle cry of pessimists such as Gov. Hayami who believe that the only way to self-improvement is through suffering and sacrifice. Such people are prone to shouting "bubble" during disinflation and probably also shout "fire" in igloos.

The proper amount of debt is whatever amount is needed to raise demand to the level of supply. If negative real rates are needed to achieve this level of debt then so be it (whether or not inflation is currently too low to achieve this is another matter, but for this reason I would prefer 5% inflation targets than 2%).

I think most people have a bias towards savings being virtuous and debt being undesirable, but this attitude only makes sense when real rates are high and the economy is in need of more savers and less spenders. For economies with not enough spenders, real rates need to be low and possibly even negative in extreme situations, and this is when the logic is reversed. Rather than declare we've taken on too much debt, it makes much more sense at the moment to declare we've taken on too much savings. Those who do take on debt should be rewarded (in the case of negative real rates they would even be paid for taking the plunge in face of uncertainty) and those who wish to stuff money under their mattress should be punished by having their investment lag inflation.

I certainly hope that we do not end up in a situation here as in Japan where the pessimists are rewarded and the optimists get crushed for no good reason.

Posted by: snsterling on September 23, 2002 11:01 PM

No, "too much debt" is a realistic assessment of the average American, who has stopped saving for the future (and old age) because he or she has thought that stock markets go up 10-15 p.a. by a law of nature.

"Household debt is at a record high relative to disposible income."

Posted by: Andrew Boucher on September 24, 2002 09:51 AM

What on earth does a bankrupcty vs. household disposable income chart have to do with anything? Also, it's just reached the shocking level it was at in 1986, so it's not that shocking.

Posted by: Jason McCullough on September 24, 2002 05:24 PM

Re: Debt charts-- Low or negative real rates would reduce the debt payments relative to disposable income even as the total amount of debt remains the same or increases, so in that sense interest rates would determine whether or not a certain amount of debt was appropriate (the chart would be altered). If demand outstrips supply, then rates should rise, new borrowers should be discouraged, and previous borrowers should be punished. And opposite for insufficent demand.

As for the idea that all Americans should save more, how exactly is the US (as a whole) supposed to delay 10% of the GDP for collection in 10 years? Normally one looks for a foreign country to be on the opposite side of the transaction, but Japan, China, maybe even Europe all seem to want to be on the same side of the transaction as us. It won't help us to deposit cash in the bank instead of spending, because all that would do is cause job losses and even less investment due to lower spending. When we go to the bank in 10 years we will have given up a trillion dollars worth of production and gained nothing, because we cannot save the services which will be needed such as health care and nursing home care. I suppose we could produce goods now and put them in storage so when the demand for services come we can just switch production from the goods to the services. Most likely the savings plan will turn out to be low wage immigrants.

While I'm sure there will be some people who will have a hard life as a result of insufficent savings, I don't see how insufficient savings can apply to this economy as a whole especially given the large productivity increases.... you just can't save some things like services, and there's no point in hoarding goods which can be produced much more efficiently in the future. Sticking the dollars under the mattress doesn't work either--that's what Japan is trying now, but I fail to see how that is preparing them for retirement of an aging population.

Posted by: snsterling on September 24, 2002 10:32 PM
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