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Commentary By Charles W. Calomiris

Stop Worrying About Deflation

Economics Finance

Central bankers – we are told – must battle deflation risk today at all costs because deflation slows growth, and may cause recessions and financial system collapses. 

I agree with the view that the Fed should be targeting an announced long-run rate of inflation. And so, I agree that monetary policy should seek to avoid sustained deflation or very low inflation as part of its inflation targeting commitment. But that is not the same as believing that a short-run deviation from 2% inflation would pose a severe economic risk – especially if it were a consequence of actions that better ensured adherence to the long-run 2% target. In particular, given the significant inflation risk associated with exiting from the Fed’s QE3 policy, beginning to scale back the Fed’s portfolio of long-maturity mortgage-backed securities and government bonds would be appropriate. That would limit medium-term inflation risk, despite the fact that it might result in a near-term rate of inflation that is slightly less than 2%. 

When is deflation a worry?

History and theory tell us that three necessary conditions must be satisfied in order for a potential deflation (or, equivalently, reductions in inflation) to be associated with adverse changes in economic activity: 

First, deflation must come as a surprise. Surprise deflations are associated with transfers of wealth from debtors to creditors, and can result in adverse changes in the balance sheets of businesses and consumers and banks. 

Second, deflation surprises must be sufficiently large and persistent. The relevant time horizon is dictated by the payment schedules of borrowers. Even if the deflation shock is large, if it lasts only a quarter or two and is reversed it is likely to have no effect in producing delinquencies or weakening most borrowers’ net worth. 

Third, the deflation shock in question must not be the result of a positive aggregate-supply shock, but rather must reflect a negative aggregate-demand shock. If deflation coincides with increases in consumers’ or businesses’ incomes (i.e., because of improvements in technology or a country’s terms of trade – such as the reduction in oil prices today), then it would not be associated with a reduction in debtors’ net worth, and therefore, will not be an source of financial distress or reduced spending by debtors. 

The Great Depression is the most obvious example of a large, destructive deflation shock that was associated with, and magnified, a large series of aggregate-demand shocks (mainly monetary policy shocks in the United States and elsewhere). 

The worldwide collapse of the money supply during the early 1930s sent prices tumbling. This was not anticipated, and therefore, people who had anticipated being able to repay their mortgage or business debts from their earnings suddenly found that, as a consequence of price decline, their revenues were contracting sharply, but their debt service obligations did not change. This “debt deflation” problem meant that many could not repay their debts, which in turn also meant that many banks were at risk of insolvency. A spike in business failures and bank failures soon resulted, which was further associated with depositor withdrawals, producing a further decrease in the supply of money, and thus, further economic decline, deflation, and balance sheet problems for borrowers and banks. 

Is there a deflation risk today, and should the Fed try to raise inflation to hit its 2% target?

The U.S. economy has been recovering, if unevenly and unimpressively, for several years. Most importantly, nominal GDP growth since 2010 has been remarkably stable and consistently has exceeded potential real GDP growth (with nominal GDP growth rates over that period varying between 3.7% and 4.3%). That makes deflation a very remote possibility. Fed and market forecasts of nominal GDP growth for the next three years are projected to increase, and the Core PCE deflator (the Fed’s current preferred indicator of inflation) is projected to remain between 1.5% and 2.0% in every year from 2015 through 2017, making the prospect of deflation even more remote. 

By all indications, inflation expectations remain well grounded at just under 2%, judging either from surveys or from implied expectations embedded in a comparison of the 10-year Treasury and 10-year TIPS. 

And, it is doubtful that the Fed would achieve much through expanded open market purchases of Treasury bonds, given that bank lending is constrained by regulatory policies and policy uncertainty, and by weak loan demand. When the Fed buys bonds it mainly expands banks’ holdings of excess reserves. QE4 would have little effect on economic activity, the supply of liquid assets, or inflation. 

In contrast to the small potential gains, the inflationary risks associated with further growth in the Fed’s balance sheet are not small. Once long-term interest rates rise (an inevitable, market-determined outcome), it will be difficult for the Fed to shrink its balance sheet to contain inflation risks. In recognition of this, the Fed has recently announced that it plans to retain its $1.7 trillion in mortgage-backed securities to maturity (many years in the future). The Fed also faces severe political risks from selling its long-term Treasury bonds at a capital loss, once long-term interest rates begin to rise. Thus, the Fed is also unlikely to sell much of its long-term Treasury bond holdings as part of its exit strategy.

The Fed’s exit strategy to contain inflation risk will rely instead on a new policy tool known as reverse repos, and on interest payments on reserves. Large interest payments to megabanks on their excess reserves – to entice them to forego lending – are likely to raise political problems for the Fed, as those payments are likely to be associated with the Fed becoming a net contributor to the government deficit. The ability and political willingness of the Fed to pursue an aggressive exit strategy, therefore, remain highly uncertain. It would not be wise to add to medium-term inflation risk by expanding the Fed’s balance sheet further. 

The stories in Europe and Japan are quite different, and much more worrying, as the slowdown in inflation there is occurring alongside low and declining growth in nominal GDP. There are real risks of large, sustained deflation surprises there. But we should not confuse the U.S. situation with those very different circumstances.

Is dollar appreciation a worrying sign?

Recently, the U.S. dollar has been appreciating. Is the appreciation of the dollar a signal of coming deflation? No, rather it reflects the strong position of the U.S. economy relative to Europe, Japan, China and other countries – real dollar appreciation is forecasting higher relative U.S. productivity growth in tradable goods.

It is true that officials in many emerging economies are sounding alarm bells over the rising dollar. These economies enjoyed massive capital inflows and temporary currency appreciations in 2009-2012 as the result of low U.S. interest rates, which have fueled investment bubbles in many asset classes. Concerns about the reversal of those flows are warranted, but it would be unwise for the Fed to try to prevent the inevitable adjustment back to more normal international capital market conditions. The greater harm would be if such concerns were to impede the necessary Fed response to inflation risk. 

The Fed should stick to its knitting, pay little attention to the dollar, and focus instead on its price stability mandate. That means pursuing policies that are likely to result in long-term price stability, not increasing long-run inflation risk in an ill-conceived attempt to pump up the price level now at all costs.


Charles W. Calomiris is a member of the Shadow Open Market Committee and the Henry Kaufman Professor of Financial Institutions at Columbia University.

For more, see Charles W. Calomiris' full paper, "Phony Deflation Worries."

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