Deflation - In Moderation - Is Compatible with a Healthy Economy

Low Interest Rates, Not Deflation Per Se, Are Potentially Troublesome

The Great Depression, as well as Japan's more recent experience, have convinced some central bankers that deflation is a dangerous thing. But the Federal Reserve Bank of Cleveland's 2002 Annual Report argues that deflation is an acceptable economic outcome, so long as it is occasional, small in magnitude, and accompanied by strong productivity growth.

In simple terms, deflation is the opposite of inflation; it describes a persistent decline in the general price level or, from another perspective, a persistent increase in the purchasing power of money. The 2002 Annual Report analyzes the economic impact of deflation and concludes that while zero, or very low, nominal interest rates that often accompany deflation can be a problem, many of the problems attributed to deflation are not unique to falling prices per se.

The key to central bankers' fear of deflation is associated with what are sometimes referred to as " liquidity traps." Liquidity traps might arise in situations where nominal interest rates are so low that interest-bearing assets and money are nearly indistinguishable. In these cases, banks, for example, can hold money as reserves and earn nearly the same return as if they loaned the money to those seeking to finance investment projects and consumption. Thus, even if the monetary authority aggressively expands the money supply, those funds may not find their way to financing productive economic opportunities.

The Annual Report emphasizes that the essence of the liquidity trap problem is low interest rates, not necessarily deflation itself. This means, on the one hand, even low positive rates of inflation can be a problem if real, i.e. inflation-adjusted, interest rates are also very low. On the other hand, the report continues, the liquidity trap is not typically a problem in times of optimism and rapid growth. Real interest rates tend to rise when the productivity of capital is rising and the demand for funds to finance consumption and investment is high. Falling prices in these situations, which the report refers to as "growth deflations," are not disruptive, as illustrated by the contemporaneous example of the Chinese economy.

The essay also highlights other examples of misplaced angst about deflation. Some business people, the report argues, mistakenly fear deflation when the issue is really the decline in the price of the goods and services they produce relative to the prices of other goods and services. Furthermore, some of the disruptions attributed to deflation arise, not because the price level is falling, but because prices are rising more slowly than anticipated.

The report says a better understanding of the dangers of deflation seems especially pertinent in light of modern central banks' near-universal commitment to low inflation and their increasing use of inflation targeting as an operational framework. And it notes that, in the final analysis, the macroeconomic impact of negative inflation hinges on other key aspects of the environment in which deflation arises — particularly price expectations, the return to capital, and the central bank's operating choices.

Federal Reserve Bank of Cleveland

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.

The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.

Media contact

Doug Campbell, doug.campbell@clev.frb.org, 513.455.4479