Wednesday, January 21, 2015

What About Deflation? Is it the Boogieman? Maybe Not So Much.

“Most of the fears surrounding deflation stem from the experience in the U.S. and elsewhere during the Great Depression. However, the early 1930s were not the only period of deflation experienced the U.S. The U.S. experienced a prolonged deflationary episode from about 1869 to 1896.

During this 27 year period, the price level declined nearly 38%, which was an average annual rate of about -1.8%. This prolonged period of deflation, however, coincided, not with economic decline, or even stagnation, but with strong economic growth.
Real GDP nearly tripled—growing at an average annual rate of 4.0%! There was little evidence of economic weakness during this era or of the cataclysmic spiraling downward we hear so much about today.”

“Despite the incredible amount of attention given to the purveyors of fear regarding deflation, neither the historical record nor economic theory provide much reason to justify all the trepidation. Except for the Great Depression, the historical record and recent experience show that most periods of mild deflation are associated with economic growth, not stagnation or decline. The Great Depression is the exception rather than the rule. Even the recentexperience of Japan provides little support for the idea that deflation itself is a source of declining output. Japan has continued to grow slowly, in large part, because of slow growth in productivity. The other fear that should be dismissed is the ineffectiveness of monetary policy when nominal interest rates at or near zero. Central banks have sufficient tools to re-inflate if they so desire. Economic theory, however, suggests that optimal monetary policy is one that leads to mild deflation. As a practical matter, and recognizing the difficulty of measuring inflation, a target range of -1% to +1% for common measures of inflation seems justified and desirable.” - Charles Plosser


Link to the entire paper appears below:

H/T: John Cochrane, University of Chicago