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The Deflation Club

Tuesday, April 27, 2010

Declining inflation, veering into outright price declines (or deflation) in some countries, continues to be a major risk to the global economy.

At about every opportunity, Federal Reserve officials remind the world that they have a plan to exit from their policy of unusual monetary accommodation. Those statements might merely be reassurances directed toward those worried that inflation will ignite, given the fodder provided by $1 trillion of reserves in the banking system. But if the Fed is planning to tighten policy sometime soon, it would be well served to study the latest forecast of the International Monetary Fund (IMF). Even a quick scan shows that declining inflation, veering into outright price declines (or deflation) in some countries, continues to be a major risk to the global economy.

Twice a year, the IMF produces a comprehensive forecast for 183 countries in its World Economic Outlook (WEO). An important contribution of the WEO cycle is its updating of data on output and inflation consistently across many countries. There are economists and firms that spend more time looking at each country individually, but no one else pulls the data together on such a scale.

Two exercises with the latest WEO forecast encapsulate the risks to the global economy.

Widespread deflation last year was worrisome. The momentum for further deflation this year suggests officials should not let down their guard.

First, the bars in the chart below plot the year-by-year share of countries in the total WEO data set posting an annual average inflation rate of 1 percent or lower. There are well-known problems with measuring price indexes, including that households shift their purchases away from items rising in price and toward cheaper goods in a manner that statisticians do not incorporate. As a consequence, a measured inflation rate of 1 percent or lower likely means that households are buying goods and services that, on average, are declining in price. A widespread decline in prices can put an economy at risk. Workers with fixed money wages look expensive to their employers as the prices of the goods and services they produce are declining. Anyone who has to repay a fixed amount of money sees the real burden, as their debt rises with deflation. Consumers might defer purchases today in favor of future bargains. Those forces restraining spending will be difficult for the national central bank to offset.

Reinhart 4.26A

The lowest that policy makers can drive down nominal (or money) interest rates is zero, so they cannot follow inflation lower once it veers into deflation. The whole process can get truly scary if the drag on spending sends prices even lower in the future. In such circumstances, a nation could get trapped in a downward deflationary spiral.

In 2009, about one-quarter of the economies followed by IMF staff experienced deflation. This is the second-largest membership in the deflation club in the 30-year history provided by the IMF.

In 2009, about one-quarter of the economies followed by IMF staff experienced deflation (the red bar in the figure). This is the second-largest membership in the deflation club in the 30-year history provided by the IMF. The club was at its most crowded in 1998, when financial crises in Russia and Asia roiled many economies along the Pacific Rim. In one sense, there is not much news that deflation took hold last year as the global economy was on the rocks, with fully half of the WEO economies posting declines in real GDP. But the prevalence of price declines does not just record prior stresses, it also points to future risks. Deflation can leave lasting scars on balance sheets, and distortions in relative prices do not necessarily lift overnight.

The good news is that the IMF staff does not apparently see 2009 as the start of a deflationary spiral. Fewer than 7 percent of the 183 countries in the WEO are projected to have effective declines in prices this year.

At the risk of snatching defeat from the jaws of even this small victory, however, note that the IMF forecasts for 2010, published last week but put to bed last month, rest on scant hard readings on prices for this year. It is a forecast, not a fact, and the IMF publishes some other information on inflation that raises a caution flag.

The whole process can get truly scary if the drag on spending sends prices even lower in the future. In such circumstances, a nation could get trapped in a downward deflationary spiral.

The WEO includes readings on inflation calculated in terms of percent changes in both annual-average and end-of-period consumer prices. If the price level was falling through the year, for example, its average would be above its level at calendar's end. Even if the price level were constant thereafter, time would have to pass before the annual average came down to the end-of-period level. As a consequence, if annual-average inflation is above its end-of-period brethren, then inflation is likely poised to fall. Thus, the details of the WEO forecast can be provide some information about the momentum of inflation, or how it is likely to change in the future.

Country by country, the gap between average and end-of-period inflation helps predict future inflation. The relationship even holds using data that aggregates across countries. By way of example, the figure below compares the share of countries with average inflation above the same year's end-of-period rate (along the horizontal axis) with the momentum in the median inflation rate among all countries (along the vertical axis). (Median inflation is the value that splits the sample right down the middle, with half above and half below. The momentum in inflation is just the difference between inflation next year and this year.) A negative relationship between the two inflation measures is quite evident, formalized in the average plotted as the blue solid line.

Reinhart 4.26B

That work done, the point to notice is the circle among the squares, which corresponds to the share of countries with average above end-of-period inflation in 2009 and the IMF's forecast of the momentum in median inflation. The year 2009 closed with 60 percent of the economies covered in the WEO having average inflation above the end-of-period value. The average relationship predicts that median inflation will decline about 1.25 percentage points from 2009 to 2010. The WEO projection, in contrast, is decidedly upbeat, with inflation rising five-eighths of a percentage point. This prediction that inflation will run above the historical line, by the way, comes after it had been much weaker than that relationship in the prior year (noted by the square associated with 2009 in the figure). Thus, central to the IMF's forecast is that inflation will rebound on the global stage in a manner far at odds with the prior three decades.

Widespread deflation last year was worrisome. The momentum for further deflation this year suggests officials should not let down their guard. Deflation is costly and rightly to be avoided. The global scale and scope of price declines and the prospect that more may be in store are probably sufficient reasons for the Federal Reserve to keep policy accommodation in place for an extended period.

Vincent Reinhart is a resident scholar at the American Enterprise Institute.

FURTHER READING: Among Reinhart’s other financial tracking for THE AMERICAN, he has asserted that “Geithner and Bernanke Are Wrong about Fed Power,” described “Bernanke’s Confidence Game,” “The Crack-up” of financial reform proposals, and “When the Fed Was Boring.” He has suggested what to do concerning how “Europe Fiddles While Greece Burns,” made “The Case for Simpler Financial Regulation,” and explained “The Right Role for the Fed.”

Image by Rob Green/Bergman Group.

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