Securing the Peace after a Trucein the War on Inflation
Vincent R. Reinhart

Central bankers in the major industrial economies have come close to
securing the peace, or in some cases, have secured it in the battle against
inflation, hostilities that lasted almost as long as the Cold War. It is
important to remember that this battle has been a good fight: both thetheory and the empirics reviewed in this paper support the central tenetof central banking that lower inflation supports faster economic growth.
However, the observation that low inflation is associated with a macroeconomic benefit does not imply that disinflation should be pursued without
limit. A particularly compelling argument in the body of work on the
optimal inflation rate is the view that price deflation, or even very low
inflation, may pose unacceptable macroeconomic risks given the lower
bound of nominal interest rates of zero. Empirical work in this paper
suggests that the zero bound is not an artifact of theoreticians but a
palpable reality. That said, the perils of the zero bound to nominal interest
rates may be seen as less threatening if a central bank is willing to be bothaggressive in providing policy accommodation when the economy may benearing the zero bound and flexible in using the available tools of policy.
Keywords: Monetary policy; Zero bound; Equilibrium interest rate
JEL Classification: E31, E5, E52

Director, Division of Monetary Affairs, Board of Governors of the Federal Reserve System (E-mail:vreinhart@frb.gov)
I would like to thank the organizers, Bennett T. McCallum and Maurice Obstfeld; my discussants,
Simon Price and Masaaki Shirakawa; many other participants for their helpful comments; andEllen Dykes and Wanda Quick for their editorial help. The views expressed are my own and are
not necessarily shared by others within the Federal Reserve System.
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION.

179

I. Introduction
In the war against inflation, in hostilities that have lasted almost as long as the Cold
War, central bankers in the major industrial economies have come close to securing
the peace or, in some cases, have already done so. In most major countries, consumer
price inflation has fallen to around 2 percent, about one-third the pace of 20 years ago(Table 1). The prevailing inflation rate of the past 10 years in the United States, about
2.25 percent, was last routinely achieved in the 1950s. And the deflation of the past
five years in Japan implies that the current level of consumer prices is now the same as
in 1995. In this fight, as in the Cold War, considerable resources were devoted tothe effort, and there were no decisive victories but rather a slow grinding down of theenemy as the advantages of the alternative regime became increasingly obvious.
Military history counsels two lessons for securing the peace after a long war. First,
do not underestimate the resilience of the old foe. Central banks should view subdued inflation as merely a temporary truce rather a final victory. Such watchfulness
and responsiveness is important, because inflation can be kept low only as long asa nation’s citizenry rightly believes that their central bank will not tolerate its resurgence. Second, shift at least some resources to position yourself to tackle the next
possible enemy. If inflation is low and not thought likely to rise appreciably, central
banks should focus at least some attention on understanding how to deal withadverse shocks given low inflation. These two lessons combine to a simple aphorism
for the conduct of monetary policy: lock in the gains from the last battle and prepare
for the next.
This paper will expand on the aphorism by discussing three lines of argument.
First, the battle against inflation has been a good fight. A changeable price levelclouds household and firm decision making and exacerbates distortions in the tax
system, pulling economic activity below its maximum sustainable level and possibly
impairing the expansion of its potential. After presenting the arguments from thetheoretical literature in Section II, I examine the data for 178 countries over the pastquarter-century in Section III and find that they appear consistent with a decidedly
negative effect of inflation on real economic growth. Moreover, this effect is robust
across econometric techniques. Thus, over time much could be lost by a failure tosecure the current low inflation.
Table 1 Average Consumer Price Inflation
Percent, annual rate over the period
1980–84
Canada8.7
France11.1
Germany
4.6
Italy
16.6
Japan
3.9
United Kingdom
9.4
United States
7.5

1985–89
4.3
3.6
1.3
6.2
1.1
4.7
3.6

1990–94
2.8
2.6
3.7
5.4
2.0
5.0
3.6

1995–99
1.6
1.3
1.1
3.0
0.4
2.7
2.3

Source: International Monetary Fund, World Economic Outlook (April 2004).

180 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

2000–04
2.4
1.8
1.2
2.5
–0.7
2.3
2.2

Securing the Peace after a Truce in the War on Inflation

Second, the observation that low inflation is associated with a macroeconomic
benefit does not imply that disinflation should be pursued without limit—the subjectof Section IV. In particular, the empirical evidence of the way a modern economy
performs in deflation is scant. Brief episodes of deflation have occurred in the pastquarter-century, but they have been the exception, not the rule. A particularlycompelling argument in the body of work on the optimal inflation rate is that pricedeflation, or even very low inflation, may pose unacceptable macroeconomic risks given
the lower bound of nominal interest rates of zero. In particular, a prevailing expectation of either low inflation or declines in the general price level limits how far thecentral bank can push down the real short-term interest rate. That may lead to output
losses, on average, if because of occasional adverse shocks to aggregate demand a very
low—perhaps negative—real interest rate is needed to encourage spending. Regression
evidence presented on the Japanese and U.S. economies over the past 30 years,
including estimates of expected real short-term interest rates and their relation to the
output gap, suggests that the full employment of resources required low real short-term
interest rates in more than a few years.
Thus, central bankers face a difficult trade-off in choosing their long-run inflation
objective. Low inflation fosters economic growth and keeps distortions to a minimum.
But too low an inflation goal—particularly if it allows veering into deflation at times—
may threaten the attainment of maximum sustainable employment by raising the lower
bound on real interest rates.
A third objective of this paper, as laid out in Section V, is to show that the perils of thezero bound to nominal interest rates may be seen as less threatening if a central bank iswilling both to be aggressive in providing policy accommodation when the economy may
be nearing the zero bound and to be flexible in using the available tools of policy. In
particular, policymakers may have scope to be explicit about their outlook for the economy and expectations for the likely path of policy to ensure that investors’ expectations
are correctly aligned. In extremis, central banks may need to resort to more direct attempts
to influence market yields through outright purchases of securities, perhaps in large
volume. In any circumstance, it is important that the public understand that the central
bank has the tools—and the willingness to use them—to prevent doubts by households’
and firms’ doubts about economic prospects from becoming self-reinforcing.
The entire discussion reflects my own views, which are not necessarily shared byothers within the Federal Reserve System.

II. Why Should Inflation Be Kept Low?
Many elegant theoretical models support the routine assertion of central bankers thatkeeping inflation low in the long run generates many benefits. Some of these benefits
are that a low inflation rate allows firms to avoid costs associated with changing theprices of the goods and services they sell, permits potential purchasers to detect relative
price changes more easily, reduces the cost associated with holding money balances(thereby cutting down on transactions costs), and vitiates nominal distortions in the
tax code. As opposed to these benefits, some analysts argue that a bit of inflation enables

181

relative prices to adjust without imposing the burden on reluctant workers to have theirnominal wages decline. Inflation may also look attractive if there is a concern thatthe zero lower bound to nominal interest rates imposes an unattractively high lower
limit on real interest rates. And concerns about the seigniorage from money creation,
especially in developing economies, may raise the attractiveness of inflation. Thesearguments can be treated in order of their implication for how low inflation should go.
A. Lowering Transactions Costs
The central bank is a zero-cost provider of a useful resource. That is, money balancesin the hands of the public may reduce the cost of transacting, aid firms in producing,and make households feel better off.1 A central bank could maximize welfare bysatiating the demand for money balances and subsequently maintaining money
growth in a manner so that the public willingly holds that high level of balances. Thisis the Friedman rule, which calls for steady contractions in the nominal money stock
so that prices decline at the rate equal to the rate of time preference, thereby ensuringthat the nominal short-term interest rate equals zero and the public demands a levelof real balances at the satiation point.2 Thus, deflation is to be welcomed, not feared,
because agents will no longer devote resources in an effort to conserve their holdingsof something that the central bank can provide at zero cost.
B. Saving Menu Costs and Reducing Distortions
An economy may have mechanisms—including institutional strictures or governmental distortions—that require the expending of resources when nominal prices
change. Canonical examples include menu costs that require a firm to devote someresources to changing prices, search costs as households have to distinguish betweenchanges in the general price level (whether up or down) and changes in relative prices,and distortions in the tax system in which the real burden of a tax changes with thenominal price level.3 Because of such resource costs, policymakers may be inclined not
to go as far as the Friedman rule—and impose the burden on the private sector in
responding to a changing (that is, falling) general price level—especially if they thinkthat the welfare benefit of increasing real balances to the satiation point is modest.
In general, such mechanisms add to the attractiveness of achieving price stability—
a zero inflation rate—because at that point none of these resource costs are incurred.4
C. Offsetting Downward Rigidities
An older argument emphasized concerns about a potential asymmetry in pricesetting.5 In particular, in their wage-setting behavior, workers may have an element ofmoney illusion or view norms of fairness and relative performance as especially
1. More formally, real money balances may enter the budget constraint by influencing transactions costs, the firm
production function, and household welfare. Feenstra (1986) discusses the equivalences among these approaches.
2. As discussed in Friedman (1969).
3. Menu costs are discussed by Mankiw (1985), search costs are the key feature of Lucas’s island parable (Lucas [1972]),
and tax distortions are central to Feldstein’s view of the optimal inflation rate (as discussed in Feldstein [1999]).
4. Of course, in a heterogeneous economy facing many shocks, relative prices may need to change frequently,
implying that menu costs would be incurred at a stable general price level and lessening the benefit of low inflation.
5. A modern treatment is provided by Akerlof, Dickens, and Perry (1996).

182 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Securing the Peace after a Truce in the War on Inflation

important. If so, they may respond poorly to wage bargains requiring declines innominal compensation even if their real wages were actually unchanged or risingbecause of a falling general price level. Such resistance to price declines poses a barrierthat may imply a less-than-full employment of resources, at least for a time, if prices
are declining. And the heterogeneity of a modern industrial economy may imply
resource losses at positive, but low, inflation rates because of such a barrier. In
particular, in a complicated economy with a range of goods and services being
produced, some relative prices will be increasing and some decreasing in response tochanges in taste and production possibilities. At a zero or low general inflation rate,
firms in the sector with declining relative prices would have to cut their nominal
prices and possibly the wages of their workers. If such cuts in money terms areresisted, some portion of the work force will have inappropriately high real-wage
demands, a situation resolved over time only by less-than-full employment. The
logical extension of this argument is that a higher general inflation rate provides coverfor reductions in real wages without outright cuts in money wages and, thereby,
will be associated with a higher level of resource utilization on average.6
D. Providing Insurance against Adverse Outcomes
The practice of modern central banking incorporates an important element of risk
management; policy needs to be designed not only to deliver the best possible average
performance of the economy but also to minimize the risks of especially adverse
outcomes. One concern is that an economy’s performance may entail significant anduncertain nonlinearities in regions that are less traveled. As one example, if inflation
were allowed to drift up to a high level, household inflation expectations mightworsen dramatically and contracts might change to include an element of indexation
in a manner that would make checking a further rise in inflation difficult. As
another, if aggregate demand softened precipitously in the face of adverse shocks, theassociated worsening of household and business confidence and increased fragility of
the financial system might exacerbate the downdraft in spending.
One region of potential nonlinearity is mapped out by the zero bound to nominalinterest rates.7 Once the nominal policy rate moves down to zero, the real short-term
interest rate equals the negative of the inflation rate expected to prevail. Such a real
rate may be too high to ensure the full employment of resources. If it is too high,then the associated output gap will put more downward pressure on inflation andlead households to lower their inflation expectations further, pushing the real rate up
and further increasing its spread above its equilibrium level. Unless some other force
provides an offsetting impetus—or monetary policy has a means to influence theeconomy beyond the level of the short-term nominal interest rate (see Section V)—
it would be only a matter of time before a deflationary dynamic sets in.8 To ensure
6. This argument might be particularly telling in a currency union where members exhibited varying degrees ofstructural flexibility.
7. McCallum (2000) explains why the zero bound binds, and Reifschneider and Williams (2000) and Coenen,
Orphanides, and Wieland (2003) discuss its implications for the strategy of monetary policy. Ahearne et al. (2002)
apply this logic to the Japanese situation.
8. The other force could be exogenous, such as fiscal policy, or endogenous, such as an important role for wealth that
ultimately leads to increases in aggregate demand through a Pigou effect.

183

against such an eventuality, the argument goes, the central bank should set a goal ofnonzero inflation in the long run; the higher the goal, the less likely the economy isto enter into the region of suspected nonlinearities.
E. Preserving the Revenue from Money Creation
A particularly relevant argument for a developing or emerging market economy is thatmoney creation represents an important source of revenue. Reducing inflation andforgoing that revenue may prove risky if alternative means of taxation or spending
reduction are unavailable, because it will require an increased reliance on debt finance,
all else being equal. Finding alternative means of funding may be problematic for
countries that have weak institutional structures which make them susceptible tofunding difficulties—those that are “debt intolerant” in the phrase of Reinhart, Rogoff,and Savastano (2003).
F. Discussion
These arguments are not competing but rather different possible mechanisms inmodern industrial economies that must be weighed in settling on the desired long-run
goal for inflation. The analysts who favor a low, potentially negative, number as theappropriate goal tend to stress the inefficiencies associated with the public’s economizing
on a resource that the central bank can make for free. The difficulty with that argument
is that estimates of significant welfare loss associated with achieving the Friedman rule
as opposed to, say, a zero inflation rate are hard to come by.9 An emphasis on menu costs
or tax distortions creates a fixed point at zero for the optimal inflation rate that is hardto dislodge, but, again, the quantitative significance of such effects is hard to assess,
especially when real shocks require relative prices to adjust fairly frequently. As for areliance on money illusion or other factors that argue for some inflation “grease” in theprice system, the norms representing an obstacle to price declines presumably wouldchange over time as workers saw increases in purchasing power at unchanged or declining money wages. The empirical evidence, at least in the United States, is ambiguous as
to whether declines in wages are uncommon (as discussed in Lebow, Saks, and Wilson[2003]). And the risk management approach weighs average economic performanceagainst adversities in the tail of potential outcomes—but the tails of distributions, bydefinition, are infrequently observed events that make quantification difficult. Emphasison the revenue from money creation is not particularly to the point of this paper’s
consideration of industrial economies.
By my reading, the weight of the evidence should incline a central bank to a low,
but nonzero, inflation goal. That judgment rests on (1) the view that the welfare gain
associated with the Friedman rule as opposed to a small positive inflation rate ismodest, (2) the lack of evidence indicating significant menu or distortionary costs,(3) the belief that money illusion is at most transitory and can be ameliorated byexplaining the central bank’s goal for inflation, and (4) an empirical assessment
about the desirability of insurance against the zero bound and the availability of
9. The intuition is that the demand for money balances is not that elastic at the range below zero, implying that notmuch consumer surplus is lost when moving from a zero nominal interest rate to a nonzero level.

184 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Securing the Peace after a Truce in the War on Inflation

monetary policy tools with uncertain effectiveness in that eventuality. But this matterultimately is empirical: one must first establish whether output growth and inflation
are associated and then address the quantitative significance of the zero bound.

III. Some Evidence on Inflation and GrowthWithout question, there has been a considerable volume of work on the correlation
between output growth and inflation over time and across countries, as exemplified
by Bruno and Easterly (1996) and Barro (1996).10 A message from this work is thatproperly identifying the correlation depends critically on including appropriate
control variables in the regression. From a central bank’s perspective, however, theunconditional correlation may provide important information, in part because
inflation may be under policymakers’ control in a way that most of the conditioning
variables in standard growth regressions are not.
In that regard, the unconditional association shows through in even the simplest
representations of the data, as in Figure 1, which plots average inflation rates (along
Figure 1 Inflation and Real GDP Growth, Averages (178 Countries, 1980 to 2004)

20

Average real GDP growth rate, percent

15
10
5
0
–5
–10
0

500

1,000

1,500
2,000
Average inflation rate, percent

OLS estimation: average real GDP growth

Constant
Average inflation rate
R-squared
Adjusted R-squared

Estimate
3.181–0.004Standard error
0.177
0.001
0.139
0.134

t-statistic
17.953–5.336

Source: International Monetary Fund, World Economic Outlook (April 2004).

10. This pairing of papers highlights the range of views on the subject. The theoretical literature just reviewed isscattered as to whether inflation should be associated with economic welfare or the level or growth rate of output.

185

the horizontal axis) against the average real GDP growth rate (along the vertical axis)
for the 178 countries in the International Monetary Fund’s World Economic Outlook(WEO) database.11 These averages are taken from the annual data available for
1980–2004 (with the WEO forecast filling in the observations for the final two yearsof the sample). A negative association is evident in the data, with a simple regression
through those points indicating that a decline of 10 percentage points in the averagerate of inflation raises real GDP growth by 0.04 percentage point. Such a decline ininflation may seem outsized relative to the contained performance of price growth of
most industrial countries in recent years, but enough observations lie in the right
portion of Figure 1 to suggest that high inflation has been a fixture in a significant
fraction of the globe. And that a fraction of the world well may have lower economic
growth, in part, because of outsized changes in the price level.12
Simple averages of inflation and real GDP growth may be influenced by large
outliers and an estimation technique, such as ordinary least squares (OLS), thatparticularly penalizes deviations from the norm. However, as is evident in Figure 2,
Figure 2 Inflation and Real GDP Growth, Medians (178 Countries, 1980 to 2004)

10

Median real GDP growth rate, percent

8
6
4
2
0
–2
–4
–6
–8
0

50

100

150

200

250
300
350
Median inflation rate, percent

OLS estimation: median real GDP growth

Constant
Median inflation rate
R-squared
Adjusted R-squared

Estimate
3.753–0.026

Standard error
0.149
0.005
0.137
0.132

t-statistic
25.210–5.275

Source: International Monetary Fund, World Economic Outlook (April 2004).

11. These data are available at www.inf.org/weo/database/april04.
12. Of course, the causation likely runs both ways. Governments with a collection of poor policies that hinder
growth may also be reduced to rely more heavily on the inflation tax. That is, inflation is an indicator of poor
macroeconomic performance. Alternatively, a central bank targeting a fixed growth of nominal income in an
economy with variable productivity growth would also generate such an association.

186 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Securing the Peace after a Truce in the War on Inflation

the negative association between inflation and output growth holds when medians
are used instead of averages. Indeed, reducing the range of variation in the horizontal
axis by a factor of five and that of the vertical axis by a factor of two makes thenegative relationship between inflation and output growth show through moreclearly. By this estimate, a reduction in inflation of 10 percentage points raises output
growth by 0.25 percentage point, not a trivial amount economically, especially when
compounded over time.
A few outliers of very high inflation rates are evident in this figure, even after aswitch to a more robust measure of central tendency. To control for these outliers in amore systematic manner, I carried out regressions of output growth on inflation inwhich the sample of observations was truncated at median inflation rates ranging from
5 percent to 100 percent, in increments of 5 percentage points. In Figure 3, which
reports these regressions, the solid line plots the point estimate as the sample varies;
it is surrounded by dashed lines that give a 95th percentile confidence band. Even if
Figure 3 Estimated Effect of Inflation on Growth (As the Sample Varies by theMedian Inflation Rate)
Plus two standard errors
0.000

Estimated coefficient–0.005–0.010–0.015

Minus twostandard errors

Estimated effect–0.020–0.025–0.030200

Number of observations

150
100
50
0
5

15

25

35

45

55

65

75
85
95
Inflation cutoff, percent

Note: The sample of observations on median annual inflation and real GDP for
178 countries is truncated (as shown along the horizontal axis) at median
inflation rates ranging from 5 percent to 100 percent.
Source: International Monetary Fund, World Economic Outlook (April 2004).

187

the sample is limited to the 70 economies that have a median inflation rate at or below
5 percent, a distinct negative relationship between inflation and economic growth
emerges. Adding higher-inflation countries actually lowers the estimated effect, butappreciably narrows the confidence band around those point estimates. Limiting thesample to countries with median inflation rates no higher than 100 percent does trim
the size of the estimated effect, but the broad flat range of the estimates suggests that arobust rule of thumb is that a decline of 10 percentage points in inflation raises output
growth by about 0.05 percentage point.
Varying the sample size is a crude attempt to control for the heterogeneity of thesample. A more robust way is to fit the relationship to minimize a specific percentile ofthe distribution of the absolute value of the errors.13 Figure 4 reports such quantile
regressions in which the coefficients are chosen to fit the percentiles ranging from thefifth to the 95th, in increments of 5 percentage points as measured along the horizontal
axis. Again, for the broad range of the sample, the estimate effect of inflation on output
growth is in the neighborhood of –0.005 and is tightly estimated, except in the attempt
to explain the two extreme tails of the distribution of the absolute value of the errors.
To be sure, the estimated effect of inflation on output growth is not large acrossthe range of regressions, particularly from the perspective of the industrial countries,
listed in Table 1, that posted declines in inflation on the order of 5 to 10 percentage
points. However, the effect differs statistically from zero and would cumulate in apresent-value sense to raise wealth and perhaps lessen the need to resort to distortionary
policy interventions.
Figure 4 Estimated Effect of Inflation on Growth (Using Quantile Regressions)

0.010

Estimated coefficient
Plus twostandard errors

0.005
0.000
–0.005–0.010Estimated effect

Minus twostandard errors–0.015–0.020
0.05

0.15

0.25

0.35

0.45

0.55

0.65

0.75

0.85

0.95
Quantile

Note: Quantile regression estimates in which the objective is to minimize theabsolute value of the errors at quantiles ranging (along the horizontal axis)
from the fifth percentile to the 95th.
Source: International Monetary Fund, World Economic Outlook (April 2004).

13. Fitting the 50th percentile, for instance, is equivalent to the least absolute median estimator. See Koenker andHallock (2002) for an introduction to quantile regression.

188 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Securing the Peace after a Truce in the War on Inflation

IV. How Can There Be Too Much of a Good Thing?
While the historical record of the past quarter-century supports the contention ofcentral banks that benefits accrue from keeping inflation low, there is a limit to theinferences possible from that data set. In particular, in the WEO sample of 178
economies, no economy posted an average or median inflation rate below zero from1980 to 2004. Indeed, of the sample only 2.25 percent had medians as low as 1 percent
and only 6.75 percent had them as low as 2 percent. That result, however, does notmean that inquiries into an economy’s performance in deflation are irrelevant. Again
using the WEO data set, Figure 5 documents the results of a simple counting exercise,with each bar recording the number of countries with deflation in any given year.
An occasional bout of deflation is not uncommon: in every year since 1980 at least
some country had declining prices, and in three years (1987, 1999, and 2000) morethan 10 percent of the sample posted price declines.14 As shown in the note to thefigure, 72 economies out of the sample of 178 experienced at least one year ofoutright deflation since 1980. These calculations, which use measured consumer
price inflation, probably overstate actual inflation because of various biases in theirconstruction. If we use the rule-of-thumb bias of 1 percentage point, which seems
appropriate in the United States, then 106 countries experienced a decline in prices
measured correctly in at least one year.15
Figure 5 Fraction of Economies in the WEO Database Experiencing Deflation(By Year, 1980 to 2004)

14

Percent of WEO sample

12
10
8
6
4
2
0
1980

82

84

86

88

90

92

94

96

98

2000

02

04

Note: Of the 178 countries in the WEO sample since 1980, 72 experienced at least
one year of deflation and 106 experienced at least one year of inflation under
1 percent.
Source: International Monetary Fund, World Economic Outlook (April 2004).

14. The bars in this figure seem to track the weighted foreign exchange value of the U.S. dollar, perhaps because theeconomies keeping their exchange rate unchanged to the dollar receive a deflationary impulse when the U.S.
currency is strong.
15. Schultze (2003) provides an update on the biases in major price indexes in the United States.

189

From a planning perspective, another aspect of the dynamics of inflation in industrial countries is of note. In particular, inflation tends both to be inertial in the short
run and unpredictable over longer periods.16 One way of seeing the latter property
is through a simple forecasting exercise. I constructed a measure of the output gap
by applying the Hodrick-Prescott (HP) filter to quarterly real GDP in Japan and theUnited States from 1970 to 2003.17 I then fit two bivariate vector autoregressions(VARs) in the estimated output gap and inflation (as measured by the logarithmicchange in the GDP deflators) using quarterly data from 1976 to 2000 and fourlags of each variable. The moving average representation of those VARs produces
the striking results evident in Figure 6: in both countries, the standard error of the
Figure 6 Standard Errors of the Forecasts of Inflation[1] United States
2.5

Percentage points

2.0
1.5
1.0
Owing to inflation equation
0.5
0.0
1

2

3

4

5

6

7

8

9

10 11 12 13 14 15 16 17 18 19 20
Quarters ahead[2] Japan
Percentage points
4.0
3.5
3.0
2.5
2.0

Owing to inflation equation

1.5
1.0
0.5
0.0
1

2

3

4

5

6

7

8

9

10 11 12 13 14 15 16 17 18 19 20
Quarters ahead

Note: From a bivariate VAR estimated from 1976/I to 2000/IV using inflation and theoutput gap, with four lags of each.

16. Atkenson and Ohanian (2001) emphasize this point.
17. The results do not depend much on the type of filter used. Because both of these countries had a similar decline
in inflation over that period, it seemed reasonable that they both had a positive output gap on average. I adjusted
the HP-filtered gaps (which by construction average to zero) so that the sample average could explain the seculardecline in inflation on the assumption that the sacrifice rate was four. (That is, an output gap of 4 percent for one
year is needed to produce a decline of 1 percentage point in inflation.)

190 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

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forecast of inflation is quite high to begin with, and it widens as the forecast interval
lengthens. A two-year-ahead forecast of inflation has a standard error of 3.5 percentage
points in Japan and of 1.75 percentage points in the United States. Moreover, thepreponderance of that uncertainty is due to shocks to the inflation equations (the lightshaded area) rather than to the gap equations, particularly for Japan.
One consequence of this imprecision is that, even beginning at a moderate rateof inflation, considerable mass may still rest on the possibility that prices could
be declining in a few years. Thus, although the empirical record does not provide
sufficient examples of sustained deflation to assess if there are systematic effects
on output growth, it has enough episodes of deflation and the inflation process issufficiently unforecastable to suggest that it is important to understand how an
economy and policy perform during deflation, in part so that we can see if or how
strenuously it should be avoided.
Part of the argument that a positive inflation rate helps protect against the zerobound rests on the belief that a negative real rate is sometimes needed to spur spending. To assess that possibility, I embarked on a two-step process of ascertaining therelationship between the output gap and the real short-term interest rate in Japan andthe United States. First, we must recognize that it is the expected, or ex ante, real
short-term interest rate that matters for spending decisions. In that regard, Mishkin(1984) provides a means of estimating the ex ante real interest rate under the null
hypothesis of the rationality of expectations. In particular, the ex post real rate, r ex post,
will differ from the ex ante real rate, r ex ante, only because of forecast errors, which
under rational expectations should be uncorrelated with anything observed concurrently or previously. Thus, the predictions of the regression of the ex post real rate attime t on macroeconomic variables observed at or before time t should provide aninefficient but unbiased estimate of the ex ante real rate.
Tables 2 and 3 report those first-stage regressions for Japan and the United States,
respectively. In both cases, the ex post real rate is defined as the nominal policy rate
Table 2 Japan: Estimation of the Ex Ante Real Policy Interest Rate
(1977/IV to 2002/IV)

Constant
Discount rate
Lagged discount rate
U.S. short rate
Equity returns
Lagged inflation (once)
Lagged inflation (twice)
Variance of residuals
Standard error of regression
R-squared
Adjusted R-squared
Durbin-Watson

Estimate
1.21
–0.57
1.40
–0.10
–0.57
–23.63–27.04Standard error
0.29
0.25
0.25
0.05
1.46
18.06
17.64

t-statistic
4.21
–2.27
5.62
–2.08
–0.39
–1.31
–1.53
1.25
1.12
0.67
0.64
0.89

Note: Estimated using OLS.

191

Table 3 United States: Estimation of the Ex Ante Real Policy Interest Rate
(1971/I to 2002/IV)
Estimate
–2.70
0.66
0.07
0.45
3.17
–194.44–99.45Constant
Nominal short rate
Lagged short rateLong rate
Equity returns
Lagged inflation (once)
Lagged inflation (twice)
Variance of residuals

Standard error
0.47
0.08
0.08
0.09
1.78
35.89
35.23

Standard error of regression
R-squared
Adjusted R-squared
Durbin-Watsont-statistic
–5.74
8.69
0.91
4.86
1.78
–5.42
–2.82
1.44
1.20
0.83
0.83
0.54

Note: Estimated using OLS.

less the realized four-quarter-ahead inflation rate as measured by the GDP deflator.
In the Japanese case, the availability of policy rate data limits the time span of theregression to 1977–2002 (with the sample ending in 2002 because of the forwardlooking nature of the inflation-compensation term). However, because I include only
those explanatory variables that are available for a longer period—the discount rate,
lagged inflation rates, and equity returns in Japan and the nominal short rate in the
United States—this relationship can be extrapolated outside the period of availabilityof the nominal policy rate.
The regressions explain a significant share of the variability of the ex post real rate
in both Japan and the United States, and I use their predictions as an explanatory
variable for the output gaps in the two countries.
Specifically, using the same HP-filtered output gaps presented earlier in thissection, I estimated the following relationship for the two countries, which includes
the error term u:
4gapt =  + ( /5)rt –kex ante +  gapt–1 + u t .
k =0

(1)

The five-quarter average of the ex ante real rate is included to capture the lags inmonetary policy, while the lagged output gap helps control for the inertia in that timeseries. This expression has two-sided dynamics introduced by the forward-looking
nature of the ex ante real rate and the backward-looking lagged gap. Both regressions
were estimated over the quarterly data available from 1976 to 2000 using two-stage
least squares (2SLS), where the instruments were the same as in the Mishkin regressions
plus lagged observations of the output gap.

192 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Securing the Peace after a Truce in the War on Inflation

A feature of this regression is that, when output is at its potential in the long run,the real short rate must equal
r equilibrium = −  / ,(2)which we can take as a measure of the equilibrium real interest rate that prevailed
over the entire sample. The results of these regressions are reported in Table 4 forJapan and Table 5 for the United States, with the implied estimates of the long-run
real equilibrium short rate given in the fourth row of both tables. Those estimates,
at 3.30 percent for Japan and 4.34 percent for the United States, are higher thanconventional estimates in part because they rely on GDP deflators rather thanconsumer price indexes. Inflation as measured by GDP deflators has tended to run
about 1 percentage lower than as measured by consumer price indexes.
These estimates differ statistically from zero, implying that the real equilibrium
short-term interest rate is unlikely to have been negative, on average, over the entire
period. But the whole-period result does not imply that such a possibility was
unlikely for sub-periods of the data. In both cases, the coefficient on the lagged gap
Table 4 Japan: Estimated Relationship between the Output Gap and the Ex AnteReal Policy Interest Rate (1976/I to 2000/IV)

Constant
Real rate
Lagged gap
Implied equilibrium real interest rate
Variance of residuals
Standard error of regression
R-squared
Adjusted R-squared
Durbin-Watson

Estimate
0.35
–0.11
0.83
3.30

Standard error
0.19
0.05
0.06
0.69

t-statistic
1.81
–2.02
14.49
4.76
0.49
0.70
0.69
0.68
2.15

Note: Estimated using 2SLS with lags of financial quotes, the output gap, and inflation.

Table 5 United States: Estimated Relationship between the Output Gap and the
Ex Ante Real Policy Interest Rate (1976/I to 2000/IV)

Constant
Real rate
Lagged gap
Implied equilibrium real interest rate
Variance of residuals
Standard error of regression
R-squared
Adjusted R-squared
Durbin-Watson

Estimate
0.33
–0.08
0.86
4.34

Standard error
0.16
0.04
0.05
0.99

t-statistic
2.10
–2.11
17.72
4.38
0.53
0.73
0.77
0.77
1.61

Note: Estimated using 2SLS with lags of financial quotes, the output gap, and inflation.

193

term is important (both numerically and statistically) in explaining the dynamics
of the gap, which as a consequence suggests that the effects of monetary policy are
distributed over time with a considerable lag.
In both cases, the ex ante real rate is negatively related to the output gap, andstatistically significantly so related. These estimates are crude in that they exclude
critical factors shaping aggregate demand, such as a measure of fiscal policy, the termsof trade, activity in important trading partners, and household real net worth.
Moreover, the estimation does not explicitly take account of the degrees of freedom
used up in the first-stage calculation of Mishkin-style real interest rates, implying that
there is a generated-regressor problem. That said, these simple equations afford a role
for monetary policy in influencing activity and are not notably more limited than theestimated relationship of Rudebusch and Svensson (1999), for instance.
The long-run estimate of the equilibrium real short-term rate seems to suggest
the zero bound to the nominal interest rate would pose no particular concern, but
persistent forces that would move the equilibrium rate away from its long-run level may
be at work in the short run. One way of capturing that possibility is to incorporate arun of systematic error terms (the u’s) in calculating intermediate-term measures of theequilibrium real rate. To be specific, I calculated a backward-looking two-year moving
average of the errors from the estimated output-gap relationship, attributed those errors
to changes in the constant term, and then asked what real short-term interest rate,
if sustained, would have held the output gap at zero.18 That is, the equation
8

rttemporary equilibrium = −( + u t–k )/ ,
k =0

(3)

allows scope for time variation in the equilibrium real interest rate. Of course, thismay allow too much time variation, in that changes in the forces of productivity andthrift, and their reflection in the equilibrium real rate, are likely to evolve more slowly
than captured in this two-year moving average.
The estimates of the equilibrium real policy rate, along with the Mishkin-style
ex ante rate, are presented in Figure 7, with those for Japan plotted in panel [1] andthose for the United States plotted in panel [2]. As is evident, the real short rateconsistent with the full employment of resources moves through a wide range—
perhaps an unbelievably wide range—and is not infrequently below zero. Moreover,policymakers seem often to chase after a moving target, in that the equilibrium rate
moves up before changes in policy. For both Japan and the United States, the sourceof the pickup in inflation in the 1970s seems to have been an actual real rate thatwas originally allowed to drift below its equilibrium and was subsequently raised
insufficiently to catch up to a rising equilibrium. Similarly, the disinflation of the 1980s
was associated with a significant stretch of policy stringency, at least as measured by theexcess of the ex ante real rate over its estimated equilibrium.
18. See Laubach and Williams (2001) for a discussion of a more satisfactory method of estimating the equilibrium
real federal funds rate.

194 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Securing the Peace after a Truce in the War on Inflation

Figure 7 Estimated Ex Ante and “Equilibrium” Real Policy Interest Rates[1] Japan
10Percent

8“Equilibrium”

Ex ante
6
4
2
0
–2
–4
Mar.
1974

Mar.
77

Mar.
80

Mar.
83

Mar.
86

Mar.
89

Mar.
92

Mar.
95

Mar.
98

Mar.
2001

Mar.
98

Mar.
2001

[2] United States
15

Percent“Equilibrium”

10

5

Ex ante

0

–5

–10

–15
Mar.
1974

Mar.
77

Mar.
80

Mar.
83

Mar.
86

Mar.
89

Mar.
92

Mar.
95

With regard to the insurance value of some inflation, the more evocative representation of the data is to sort the observations for both countries by the level of theestimated equilibrium real interest rate, as in the cumulative distributions plotted in
Figure 8. In particular, in about one in five of the quarters since 1976 the estimatedequilibrium real rate was in negative territory. Thus, strict price stability—a measured
inflation rate of zero—would have bound the central bank from providing interest
rate stimulus sufficient to eliminate the output gap on many occasions.

195

Figure 8 Cumulative Distribution of Estimates of the “Equilibrium” Real Policy
Interest Rate
[1] Japan
100

Percent

80

60

40

20

0
–4

–3

–2

–1

0

1

2
3
4
5
6
7
8
Estimated “equilibrium” real policy rate, percent[2] United States
100

Percent

80
60
40
20
0
–10

–7

–4

–1

2
5
8
11
14
Estimated “equilibrium” real policy rate, percent

From a risk management perspective, the region to the left of zero can be reducedby allowing some positive inflation, acknowledging that some efficiency losses may
occur as households economize on money balances, resources are used up changing
price tags, and tax distortions loom larger. However, the need to avoid that region
depends critically on policymakers’ assessment of their ability to prevent such outcomes
and the efficacy of their tools should the nominal short rate become pinned to zero.

196 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Securing the Peace after a Truce in the War on Inflation

V. What Are the Tools of Policy in a Period of Low Inflation?
Japan’s experience at and the United States’ close brush with the zero lower boundto nominal interest rates have elicited considerable attention from the economics
profession. Some contributions have rigorously framed the problem in a generalequilibrium setting, for example, Woodford’s description of the rate of time preference
dipping for a time into negative territory (Woodford [2003]). Some models haveemphasized the importance of shaping expectations about the future path of thepolicy rate, either by committing to a permanent expansion in the monetary base (asin Auerbach and Obstfeld [2004]) or by being explicit about future interest rate action(as in Eggertsson and Woodford [2003]). And in some examples, other policy levers
provide the needed impetus, whether fiscal policy (Eggertsson [2003]) or the external
sector (Svensson [2001]). Less work has been done thus far on empirical aspects of thezero bound, with the exception of Nagayasu’s explication of the behavior of the term
structure of interest rates during the zero interest rate period (Nagayasu [2004]) and
Shirakawa’s examination of balance-sheet adjustment during that episode (Shirakawa[2001]). The purpose of this section is not to review the options of policymaking
in extremis (as is done in Bernanke [2002] or Bernanke and Reinhart [2004]), butrather to point out two lessons of more general practicality to a central bank that is
operating in a low-inflation environment.
The first lesson is that policymakers operating at a nominal interest rate above thezero bound should appreciate that their actions can make becoming pinned at the zerobound less likely. In particular, two strategies for action exist if there is significant
potential for an adverse shock. Policymakers can “save their ammunition” by waiting
until the shock materializes before acting, or they can move preemptively before
the expected shock. Simulation work in a large-scale econometric model (such as
Reifschneider and Williams [2000]) indicates that it is better to have the economy on
the strongest possible footing when the shock hits by easing before, even accepting thefact that policy would be mispositioned should the shock not materialize. Unless theact of easing has an independent effect from the level of the rate (which might occur,
say, if policy action timed with the release of adverse news bolstered confidence),
moving preemptively works better.
There are trade-offs, of course, in that erring toward the side of ease when rates are
low would create an inflation bias, but the earlier discussion suggests that an inflation
goal of zero may be too low. And a systematic tendency to err toward an easier policy
when adverse shocks bulk large and nominal interest rates are low can be offset by awillingness to unwind that accommodation quickly once the situation clears.
The second general lesson to take away from the work on the zero bound is thatthe short-term nominal interest rate under the direct control of policymakers has
little direct effect on behavior. Rather, it is the current value of the short-term rateand its expected future course that gets embedded into capital values and that thereby
affects spending decisions. Even if the nominal short-term rate is low, a central bankcan provide impetus to the economy if it can convince investors that the rate may
hold at that level for longer than previously expected or that it may go even lower.
For such assurance to be credible, a policymaker’s description of its outlook and197

public understanding of the policymaker’s objectives must combine to indicate a
subdued path of short-term rates for, to coin a phrase, a considerable period.
That this lesson is nothing new is an understatement. In 1936, John Maynard
Keynes explained in The General Theory of Employment, Interest, and Money:[T]he rate of interest is a highly conventional, rather than a highly psychological, phenomenon. For its actual value is largely governed by the prevailingview as to what its value is expected to be.19
Lord Keynes went on to draw out the policy implication:
Such comfort as we can fairly take from more encouraging reflections must be
drawn from the hope that, precisely because the convention is not rooted insecure knowledge, it will not be always unduly resistant to a modest measureof persistence and consistency of purpose by the monetary authority.20
Work in the field since then has increasingly viewed expectations about the future
course of interest rates as centrally connected to investors’ outlook for the economy,rather than as a deus ex machina convention. But these insights offer the possibility
that, by conveying its view of the economic outlook to the public, perhaps with amodest measure of “persistence and consistency of purpose,” a monetary authority
can induce helpful adjustments in capital values (in a manner described rigorously by
Woodford [2003]).
An interesting observation in that regard can be gotten by examining the volatilityof private-sector interest rates along the term structure in Japan and the UnitedStates. Table 6 records the absolute weekly change in one-month deposit rates andswap yields at the two-, three-, five-, and 10-year maturity from 1990 to mid-year
2004. As is evident, yields at the front end of the term structure—at the one-monthmaturity—have been equally variable in both countries, at about a mean absolutechange of 5 basis points per month. But volatilities have stepped up markedly
moving out the yield curve in the United States in a manner not observed in Japan.
At the 10-year horizon, swap yields in the United States have been almost twice
as volatile as those in Japan. In the sense of Keynes and Woodford, U.S. markets
Table 6 Changes in Selected Nominal Interest Rates
Mean absolute weekly change, basis points, January 1, 1990 to May 21, 2004
Japan
United States
One-month deposits
5.2
5.7
Two-year swaps
6.0
11.4
Three-year swaps
6.8
11.6
Five-year swaps
6.8
11.6
10-year swaps
6.7
10.9
Source: Bloomberg.
19. Keynes (1936, p. 203).
20. Keynes (1936, p. 204).

198 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Securing the Peace after a Truce in the War on Inflation

appear to have been getting signals that vary more significantly as to the appropriate
allocation of capital than do those in Japanese markets.
These longer-period averages are representative of finer slices of the data, as isclear in Figure 9, which plots measures of the volatility of rates each year since 1990.
Short rates, year by year, have been equally variable in the United States and in Japan.
But this has decidedly not been the case further out on the yield curve. One wonders
if a policy tool—encouraging changes in the longer-run outlook—has either been left
unexploited or for institutional reasons has been less available for use in Japan than in
the United States.
Acting preemptively and shaping expectations about the economy are tools thatare available to central banks at all times, and they may be particularly importantwhen nonlinearities are feared to be adverse. But policy need not be constrained
when events turn adverse and these two tools prove inadequate to the task. In
particular, when the funds rate is zero, a central bank can oversupply reserves at thatinterest rate floor, a tactic that is described by Auerbach and Obstfeld (2004). In effect,a zero nominal funds rate is a classic example of the Brunner and Meltzer (1973)
problem, in that the nominal rate is not informative about the stance of policy when
it is attained at a depressed demand for reserves. Increasing the quantity of reserves atthat point—that is, oversupplying reserves—may have an effect. In point of fact, ourunderstanding of the monetary transmission mechanism is sufficiently imprecise not
Figure 9 Average Absolute Weekly Change in Selected Private Rates[1] One-Month Deposit Rate
0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00

[2] Two-Year Swap Yield

Percentage points

United StatesJapan
1990 92

94

96

98 2000 02

04[3] Five-Year Swap Yield
0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00

94

96

Percentage points

1990 92

94

96

98 2000 02

04

98 2000 02

04[4] 10-Year Swap Yield

Percentage points

1990 92

0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00

0.16
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00
98 2000 02

04

Percentage points

1990 92

94

96

Source: Bloomberg.

199

to rule out a quantity channel that might work through the size of banks’ balance
sheets or through banks’ willingness to lend.
If oversupplying reserves has no obviously discernible effect, the central bankcan attack the term structure of interest rates more directly. In particular, if asset
prices adjust insufficiently to stimulate spending, then open market purchases of
longer-term Treasuries, in sizable quantities if necessary, can move term premiums
lower. Of course, such a promise to put a ceiling on parts of the yield curve would be
reinforced if it were associated with a credible promise to keep the short rate along apath consistent with those long-term rates.
No doubt, all of these policy mechanisms are uncertain. Such uncertainty
about containing deflation implies that the best policy is to deal with deflation bystrenuously avoiding it through preemptive action. Perhaps the most importantmessage from Lord Keynes, filtered through what has been learned in the 70 years
since he wrote, is:[A] monetary policy which strikes public opinion as being experimental incharacter or easily liable to change may fail in its objective of greatly reducing
the long-term rate of interest . . .21
Improvisation indicates a commendable flexibility of action, but is an unfortunate
trait in an entity relied upon to provide a predictable backdrop against whichinvestors price long-lived assets. Before a central bank puts even slim odds on policy
alternatives at the zero bound to nominal interest rates, it should use its conventional
interest rate stimulus as aggressively as possible and should explain the alternative—
and ultimately effective—sources of stimulus once the zero bound takes hold.

References

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2002.
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Brookings Papers on Economic Activity, 1, 1996, pp. 1–76.
Atkenson, Andrew, and Lee E. Ohanian, “Are Phillips Curves Useful for Forecasting Inflation?”
Quarterly Review, Federal Reserve Bank of Minneapolis, Winter, 2001, pp. 2–11.
Auerbach, Alan J., and Maurice Obstfeld, “The Case for Open-Market Purchases in a Liquidity Trap,”
working paper, University of California at Berkeley, 2004.
Barro, Robert J., “Inflation and Growth,” Review, Federal Reserve Bank of St. Louis, May/June, 1996,
pp. 153–169.
Bernanke, Ben S., “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” remarks before the National
Economists’ Club, Washington, D.C., November 21, 2002.
———, and Vincent Reinhart, “Conducting Monetary Policy at Very Low Short-Term Interest Rates,”
American Economic Review, 94, 2004, pp. 85–90.
Brunner, Karl, and Allan H. Meltzer, “Mr. Hicks and the ‘Monetarists,’” Economica, 40, 1973, pp. 44–59.

21. Keynes (1936, p. 203).

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Bruno, Michael, and William R. Easterly, “Inflation and Growth: In Search of a Stable Relationship,”Review, 78 (3), Federal Reserve Bank of St. Louis, 1996, pp. 139–146.
Coenen, Gunter, Athanasios Orphanides, and Wolker Wieland, “Price Stability and Monetary Policy
Effectiveness When Nominal Interest Rates Are Bounded at Zero,” CEPR Discussion Paper
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Eggertsson, Gauti B., “How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible,”working paper, 2003.
———, and Michael Woodford, “The Zero Bound on Interest Rates and Optimal Monetary Policy,”
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Feenstra, Robert, “Functional Equivalence between Liquidity Cost and the Utility of Money,” Journalof Monetary Economics, 17, 1986, pp. 271–291.
Feldstein, Martin, ed. The Costs and Benefits of Price Stability, Chicago: University of Chicago Press for
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pp. 143–156.
Laubach, Thomas, and John C. Williams, “Measuring the Natural Rate of Interest,” Board ofGovernors of the Federal Reserve System, Finance and Economics Discussion Series Working
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pp. 103–124.
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Rates,” Journal of Money, Credit and Banking, 32, 2000, pp. 870–904.
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Nagayasu, Jun, “The Term Structure of Interest Rates and Monetary Policy during a Zero Interest Rate
Period,” Monetary and Economic Studies, 22 (2), Institute for Monetary and Economic Studies,Bank of Japan, 2004, pp. 19–43.
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Taylor, ed. Monetary Policy Rules, Chicago: University of Chicago Press, 1999.
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201

Comment
SIMON PRICE22Bank of England

I. Introduction
I am very grateful to the organizers for inviting me to act as a discussant on thispaper, which brings a nice mix of theoretical analysis and empirical evidence to theimportant question of macroeconomic policy in a low-inflation world.
As central bankers, our collective aim is “price stability,” which means low andsteady inflation. Mervyn King, then deputy governor and now governor of the Bankof England, discussed this topic in King (2002). In the United Kingdom, as in manyother parts of the world, price stability has arrived. It appears to have been associated,certainly in the United Kingdom at least, with a more stable macroeconomic environment, with fewer surprises to inflation, less inflation uncertainty, lower real interest rates, and lower output volatility. This does demonstrate that it is rather hard todisentangle low levels of and low volatility in inflation, as they tend to go together.
Vincent R. Reinhart’s paper considers some of the benefits of this outcome, thenfocuses on a potential constraint on policy, the zero bound, before considering what
the policy response should be.

II. Low Inflation and Growth
In the first half of the paper, it is argued that low inflation brings higher growth. Thismeans there are profound benefits from a low-inflation policy, as the present value ofeven small increases in growth is large.
But on the evidence, I think we need to be somewhat cautious. This is partly
because there is an important reservation about the direction of causality, which ispractically hard to resolve. Does the causality run from low inflation to stability, orfrom a more stable economic environment to lower inflation? There have been many
shocks over the past low-inflation decade and a half, of course. But perhaps goodmonetary policy delivers both low and steady inflation and steady growth. And there
are further grounds for skepticism about how strong the evidence is for a link
between low inflation and high growth.
A. Theory
Reinhart rehearses the major arguments, which are also discussed in King (2002).
I shall not try to cover all the ground in the short time available to me, but I havea few observations.
Our standard model is a dynamic stochastic general equilibrium (DSGE) modelwith some real and nominal rigidities. As Bennett T. McCallum suggested in his
22. These comments represent the views and analysis of the author, and should not be thought to represent those of
the Bank of England or Monetary Policy Committee members.

202 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment

opening address is broadly true about modern macroeconomics, these models do nothave anything to say about the effect of steady-state inflation (because they are notmonetary models). In fact they are detrended—linearized around a steady state andconstant inflation rate, usually assumed to be zero for simplicity,23 so it is simply
impossible to begin exploring the implications of differing steady-state inflation
rates. Perhaps that is because there is not an issue? One has to look elsewhere foran explanation.
One might broadly characterize theories as those where inflation affects the rate of
return on investment (in physical or human capital) and those where there is an
impact on efficiency, or total factor productivity. I think we have also to distinguishbetween effects on the growth and the level of output. Many (in fact, arguably, most)of the theories and stories suggest level effects, not rates of growth.
Temple (2000) suggested in his survey of this topic that the arguments
about inflation and growth are often “stories” rather than theories—some may be“taller” than others. Be that as it may, I want to make some remarks regarding threebroad stories.
1. Relative price variability
This has to do with efficiency.
The level of inflation is positively associated with volatility. There is someevidence that relative price variations are larger too. This follows more or lessimmediately from models of price setting with heterogeneity—higher inflation willlead to larger revisions in nominal prices. There must be a welfare loss from this(prices are wrong) although, plausibly, consumers may gain from more price variability if they are aware of the degree of price dispersion (as indirect utility is convex
in prices). And with arguably small costs of price adjustment and small losses in the
profit-maximizing region, it is rather hard to see that welfare losses are large. Indeed,
as relative prices continually change, it is not at all clear that menu costs are lower atzero percent than 2 percent—or even 5 percent. Currently in the United Kingdom,
while total inflation hovers around 2 percent, the price of services increases at
5 percent or so per annum, while for many goods prices are falling.
2. Uncertainty
If this volatility leads to uncertainty, there will be a further welfare loss: nevertheless,growth need not necessarily suffer. The usual link argued to exist between uncertainty and output works through the capital stock. But the effects of uncertainty on
the capital stock are themselves uncertain. We have known for a long time (since
Hartman [1972]) that there is quite likely to be a positive effect of uncertainty on thecapital stock. The real options approach to investment under uncertainty that has
become popular recently (see Dixit and Pindyck [1994]) does not reverse this—it
mainly has implications for the timing and chunkiness of investment at the firmlevel. However, increased uncertainty must have an effect on the required rate of
return. Uncertainty also reduces the effectiveness of monetary policy in most of themodels I am aware of—although we need to beware of why inflation is uncertain; it
could be policy shocks.
23. It should be said that this may not be an innocuous assumption. Bakhshi et al. (2003) explore the consequencesof linearizations around different steady states for the New Keynesian Phillips curve.

203

Other mechanisms that might reduce welfare by more include those put forward
by Ball and Romer (1993). Customers might enter inefficient long-run relationships
as the current price is a poor signal of the long run; and if demand becomes moreinelastic, markups rise.
3. Inflation and rates of return
The Tobin effect (lower returns on money encouraging excess physical investment)
leads to more investment as inflation rises, which anti-inflationers find awkward,
although it is hard to see that this amounts to much when holdings of money are sosmall relative to the capital stock.
A more popular macro approach is to follow Stockman (1981), in which the
inflation rate acts as a tax on investment, through a cash-in-advance constraint on thepurchase of capital goods. I have always thought of cash-in-advance as mainly ananalytically convenient fiction, perhaps more plausible for households. Do firms
really need cash before they invest? But in this context, periods of high inflation willlead to lower investment and, hence, a lower capital stock. This reduces the demand
for labor and leads to lower employment, output, and real wages.
An effect on long-run growth requires more. A recent paper by Gillman, Harris,and Mátyás (2002) combines cash-in-advance with endogenous growth. Both parts
are important: if one wants to explain long-run growth, a negative correlation
between inflation, on the one hand, and output (and investment and consumption)on the other is insufficient.
Finally, I would add seigniorage to Reinhart’s list of arguments supporting a little
inflation (not in the paper, although mentioned in the presentation). All taxes distort:
the inflation tax is at least cheap to collect and hard to evade.
B. Evidence
I was not that convinced by the unconditional evidence presented in the paper. It issurely untrue that the monetary authorities can control inflation completely at all
times. In the short run at least, the inflation outcome must depend on the shocks
hitting the economy.
My view of the voluminous literature is that it is clear that very high inflation isbad, and inflation and output growth are negatively correlated in high-inflation
countries: e.g., Fischer, Sahay, and Vegh (2002). But for inflation rates in single
digits, the impact of inflation on growth is less clear.
There is, however, controversy over the nature of the relationship at low inflation
rates. There is some debate about the cutoff. Many people would put it at 40+ percent,but Sarel (1996) searches for a breakpoint in the relationship between inflation andgrowth, and locates it at an annual rate of 8 percent, while Khan and Senhadji (2000)
analyze this relationship separately for industrial countries and developing countries
and find that “the threshold level of inflation above which inflation significantly
slows growth is estimated at 1–3 percent for industrial countries and 7–11 percent fordeveloping countries.” (Below the threshold, however, inflation benefits growth.24 )24. But the estimated impact in Khan and Senhadji (2000) seems large. Moreover, if inflation works via thereduction of investment, why condition on investment, as they do? No account is taken of simultaneity.

204 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment

We need to be very clear about frequencies. It is hardly odd that there is a shortrun correlation between changes in GDP and inflation. Temple (2000) observes that
there is a contrast between the cross-section (very long averages) and panel results(typically annual and five-year averages): no effect and a negative effect, respectively.
Perhaps this means there is no long-run effect. This is something that emerges
from several of the papers in Feldstein (1999), supported by evidence from theOrganisation for Economic Co-operation and Development (Andrés and Hernando[1999]), and my take on Reinhart’s stories is that they largely relate to the level.
In all these studies, the causality problem is profound. Low growth reduces tax
revenues, increasing the demand for seigniorage. Supply shocks lead inflation andgrowth to move together. Low-growth episodes lead to expansionary policy that raises
inflation before growth responds. Granger causality tests do not necessarily resolvethese questions.
Good instruments may be hard to find. Barro (1995) uses bank independence,
lagged inflation, and colonial status. Institutional “natural experiments” are attractive
instruments, but may not be exogenous. And the first of these may not be so goodfor developing countries; the last may be independently correlated with otherrelevant factors. Ghosh and Phillips (1998) use similar institutional variables anda similar exchange rate regime. Gillman, Harris, and Mátyás (2002) use lagged
money growth on the grounds that in the model it is exogenous: perhaps not in theworld, however.
C. Conclusion on the Evidence?
If I were forced to take a view, I would conclude that low inflation tends to be
associated with steady growth, perhaps at a higher rate. But given the difficulties thatarise in the interpretation of the many empirical studies, I would rather focus on thetheoretical mechanisms. These strike me as suggesting a rather small levels effect.
I suggest that good monetary policy can deliver price stability and reduced output
volatility and increase welfare. But it is the shocks and policy responses that deliver
the observed correlations: it is the absence of monetary shocks and good policy thathave delivered the benign outcome.
Having said this, it is pretty clear that if policy can deliver price stability with lessreal volatility, then even without a positive effect of low inflation on growth it is hard
to see that anyone would want to pursue any other policy.

III. The Zero BoundLet us now look at the consequences of low inflation. Some of these issues wererehearsed in Yates (2003).
First, what might the equilibrium rate be, given the current target? The Bank ofEngland does not take a view on what the natural rate of interest is, as although thenotion is theoretically coherent and arguably has some advantages over alternative
summaries of the balance of demand and supply like the output gap, there is no
definitive way of calculating it. But the number for the natural real rate from205

calibrated models (e.g., Neiss and Nelson [2003]) implicitly based on the historical
average, is often set at about three, and an empirically based estimate by Larsen and
McKeown (2004) suggests the figure might be around 3.5 percent, averaging over the
recent past. So the nominal rate might perhaps be around 5 percent, a good way
away from zero, and similar to Reinhart’s estimate for the United States, although
this ballpark number is uncertain and will vary over time, so it is really just a possible
point in a wide and fluctuating band.
Accepting that the true number is unknown, given this kind of equilibrium rate,is there a practical risk of hitting the zero bound? (And speaking as I do at thisconference in Japan, it is clear given the recent history of interest rates here that one
does not want to be too sanguine.) Judging from Reinhart’s estimates, the answer
is yes. Those results are based on a neat and simple method. (I would guess theconfidence interval is understated, however: I do not believe the simple dynamics
are right, and there is a generated regressor problem.) But are the estimates of
the amount of time negative real rates are required plausible? Yates (2003) put
together five estimates of the probability of hitting the zero bound at different steadystate inflation rates for Japan, the United States, and Canada. The probability at azero target varies from about 1 percent to about 17 percent. But of the estimates,
Reifschneider and Williams (2000), who use the Federal Reserve Board model of
the U.S. economy, put it at about 14 percent, in the same region as Reinhart. I do
wonder, though, if the numbers from the 1970s should be included. We were hit
by an exceptional supply shock then, but it was followed up with a series of policy
mistakes. So I would argue that those large negative numbers were partly driven bymonetary shocks unlikely to reoccur. I also note that the 1990s ex ante rate was far
above the long run—reflecting the mistaken over-tightening of policy at that time.
Nevertheless, the possibility of hitting a zero bound clearly exists and it appears
that there is a real issue. What then to do about the bound once we hit it (althoughhitting it is not usually going to be a disaster—more, that policy cannot respond as
quickly as we would like)?
Before considering this, however, perhaps I should mention a proposal put forward
by Buiter and Panigirtzoglou (2000) to pay negative interest on notes and coins, andtherefore to lower the bound. For some reason, this has not been adopted. I suspect
this would be ruled out on grounds of administrative complexity—and perhaps
because of the likely substitution of foreign for domestic currencies by the public.
I found little to disagree with in the paper’s analysis, but would make a couple ofcomments. It was Goodfriend (1991) who first introduced the idea of gradualism inthis context, which Woodford later formalized. Gradualism—persistence—in shortrate setting influences long rates in a helpful way, which has a payoff when weapproach the zero bound. There is a cost: you relinquish optimal short-rate policy toreap an occasional, unlikely benefit. Short rates move by less than we would likewhen we are away from the bound.
An attractive solution avoiding this cost would be for behavior to change
appropriately only when we approach the bound; but the public may not believethat the authorities have adopted a new policy. So this leads to a discussion of
credibility. If we could make credible announcements that policy is now more

206 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment

persistent when we are near the bound, that would help (Reifschneider and Williams[2000]). Reinhart places a strong premium on making a clear explanation of
why policy is different (at the zero bound). I think this is somewhat hopeful. Banks
regularly try to explain and educate, but it often seems as if lessons take a long time
to be absorbed.
In the U.K. context, it seems clear that inflation expectations are now firmly
anchored on the target. As it is expectations that matter for real rates, it follows
that a good defense against the bound is a credible nonzero target. If inflation
expectations do not move with actual inflation, in principle real rates can survive
protracted low-inflation episodes. Naturally, it does help to have an explicit target inthis context.

References

Andrés, J., and I. Hernando, “Does Inflation Harm Economic Growth? Evidence from the OECD,” in
M. Feldstein, ed. The Costs and Benefits of Price Stability, Chicago: University of Chicago Press
for the National Bureau of Economic Research, 1999, Chapter 8.
Bakhshi, H., P. Burriel-Llombart, H. Khan, and B. Rudolf, “Endogenous Price Stickiness, Trend
Inflation, and the New Keynesian Phillips Curve,” Bank of England Working Paper No. 191,
Bank of England, 2003.
Ball, L., and D. Romer, “Inflation and the Informativeness of Prices,” NBER Working Paper No. 4267,
National Bureau of Economic Research, 1993.
Barro, R., “Inflation and Economic Growth,” Bank of England Quarterly Bulletin, Bank of England,
35, May, 1995, pp. 166–176.
Buiter, W. H., and N. Panigirtzoglou, “Liquidity Traps: How to Avoid Them and How to EscapeThem,” Bank of England Working Paper No. 111, Bank of England, 2000.
Dixit, A. K., and R. S. Pindyck, Investment under Uncertainty, Princeton: Princeton University Press,
1994.
Feldstein, M., ed. The Costs and Benefits of Price Stability, Chicago: University of Chicago Press for the
National Bureau of Economic Research, 1999.
Fischer, S., R. Sahay, and C. Vegh, “Modern Hyper- and High Inflations,” Journal of Economic
Literature, 40, 2002, pp. 837–880.
Ghosh, A., and S. Phillips, “Inflation, Disinflation, and Growth,” IMF Working Paper No. 98-68,
International Monetary Fund, 1998.
Gillman, M., M. Harris, and L. Mátyás, “Inflation and Growth: Some Theory and Evidence,” mimeo,
2002.
Goodfriend, M., “Interest Rates and the Conduct of Monetary Policy,” Carnegie-Rochester Conference
Series on Public Policy, 34, 1991, pp. 7–30.
Hartman, R., “The Effects of Price and Cost Uncertainty on Investment,” Journal of Economic Theory,
5, 1972, pp. 258–266.
Khan, M. S., and A. S. Senhadji, “Threshold Effects in the Relationship between Inflation and
Growth,” IMF Staff Papers, 48, International Monetary Fund, 2000.
King, M., “The Inflation Target Ten Years On,” Bank of England Quarterly Bulletin, Bank of England,
Winter, 2002.
Larsen, J., and J. McKeown, “The Informational Content of Empirical Measures of Real Interest Rateand Output Gaps for the United Kingdom,” Bank of England Working Paper No. 224, Bankof England, 2004.
Neiss, K., and E. Nelson, “The Real Interest Rate Gap as an Inflation Indicator,” Macroeconomic
Dynamics, 7, 2003, pp. 239–262.

207

Reifschneider, D., and J. C. Williams, “Three Lessons for Monetary Policy in a Low Inflation Era,”
Journal of Money, Credit and Banking, 32 (4), 2000, pp. 936–966.
Sarel, M., “Nonlinear Effects of Inflation on Economic Growth,” IMF Staff Papers, 43, 1996,
International Monetary Fund, pp. 199–215.
Stockman, A. C., “Anticipated Inflation and the Capital Stock in a Cash-in-Advance Economy,”
Journal of Monetary Economics, 8 (3), 1981, pp. 387–393.
Temple, J., ‘”Inflation and Growth: Stories Short and Tall,” Journal of Economic Surveys, 14, 2000,
pp. 395–426.
Yates, T., “Monetary Policy and the Zero Bound to Nominal Interest Rates,” Bank of England Quarterly
Bulletin, Bank of England, Spring, 2003, pp. 27–37.

Comment
MASAAKI SHIRAKAWA
Bank of Japan
The paper by Vincent R. Reinhart raises a number of interesting issues. My purpose
here is to comment on his paper from the viewpoint of a central bank staff member
who has been involved in implementing various unconventional measures under
deflation. Although such measures have never been undertaken by other central banks,
they fully follow the spirit of John Maynard Keynes cited by Reinhart. By unconventional measures, I mean the zero interest rate policy, a massive increase in bank reserves,a commitment to continue with the zero interest rate policy or quantitative easing, andthe purchase of equities held by banks as well as of asset-backed securities.
Reinhart’s paper can be summarized by the following two propositions. First, very
low inflation, or deflation, may pose unacceptable macroeconomic risks given the zerobound of nominal interest rates. Second, the peril of the zero bound of nominalinterest rates may appear less threatening if a central bank is willing to be aggressive
in conducting accommodative policy when the economy is nearing the zero boundand to be flexible in using available policy tools. In light of the Japanese experience,
my initial, summary comment on these propositions is that it all depends. Specifically,
it depends on what type of “war” we have in mind.
Let me elaborate on my summary comment on the two propositions, startingwith the first. As economic history tells us, deflation was not an unusual phenomenon
until the 20th century. In fact, there were not a few periods of sustainable growthunder deflation.
The major reason why we are concerned about deflation is, obviously, that it may
cause economic activity to stagnate. Viewed from this perspective, the main cause ofJapan’s economic stagnation since the 1990s has not been a decline in the generalprice level. During this period, both the general price level and nominal interest rates
have been declining, and the rate of decline in the consumer price index (CPI) has
been moderate, as is shown in Figure 1. The situation in the 1990s is quite a contrast
to that in the 1930s in the United States and the 1920s in Japan when real interest
rates increased.
The main cause of Japan’s economic stagnation since the 1990s has been the asset
price deflation and its impact on the economy rather than the decline in the general

208 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment

Figure 1 Asset Prices and General Prices

0.2

1989/IV = 0, in log scale

0.0
–0.2
–0.4
–0.6
–0.8
–1.0
–1.2
–1.4
–1.6
–1.8

Land prices
Stock prices
Core CPI–2.0
1989 90

91

92

93

94

95

96

97

98

99 2000 01

02

03

04

Note: CPI excluding fresh food is seasonally adjusted by X-12-ARIMA with options of(0 1 2)(0 1 1) ARIMA model and level shifts in April 1989 and April 1997, when
the consumption tax was respectively introduced and subsequently hiked.
Sources: Bank of Japan, “Financial and Economic Statistics Monthly”; Ministryof Public Management, Home Affairs, Posts and Telecommunications,“Consumer Price Index”; Japan Real Estate Institute, “Urban Land
Price Index.”

price level. The substantial rise and fall in asset prices have been unprecedented.
Cumulative capital loss of land and equity holdings as a percentage of nominal GDP
amounts to about 220 percent, as is shown in Figure 2. Asset price deflation has affected
not only the demand side but also the supply side as was discussed by Okina andShiratsuka (2004) at the previous session. Thus, the trend growth rate has declined.
One reason why I feel some uneasiness about Reinhart’s first proposition is thathe seems to analyze the economic stagnation solely in terms of the general pricelevel rather than asset prices. It seems to me that such an approach is not a suitable
analytical framework, at least for an economy in which the decline in asset prices
plays an overwhelmingly dominant role.
Another reason for my uneasiness about the first proposition in his paper is thatJapan’s economy is actually expanding, while prices are still falling in recent years, as
is shown in Figure 3. If we pursue the logic behind the peril of deflation, deflation
leads to a contraction of economic activity, which in turn leads to further deflation.
Thus, the economy is bound to fall into a vicious cycle of deflation, or a deflationary
spiral. However, we have not observed a deflationary spiral in Japan, as is shown in
Figure 3. Among several hypotheses, one possible explanation for this is that nominal
wages are being determined flexibly without any downward rigidity. In Japan, nominal wages have been falling faster than consumer prices. Kuroda and Yamamoto

209

Figure 2 Asset Price Deflation

150

Ratio to nominal GDP, percent(+452 percent)(+187 percent)

100
50
0
–50

(–221 percent)–100
1956 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98
Source: Cabinet Office, “National Accounts.”

Figure 3 CPI and Real GDP Growth7

Changes from the previous year, percent

6

Real GDP
Core CPI

5
4
3
2
1
0
–1
–2
–3
–4
1990 91

92

93

94

95

96

97

98

99 2000 01

02

03

04

Sources: Cabinet Office, “National Accounts”; Ministry of Public Management, Home
Affairs, Posts and Telecommunications, “Consumer Price Index.”(2003), who have applied the analysis of Akerlof, Dickens, and Perry (1996) to theJapanese economy, suggest that wage determination is more flexible in Japan than in
the United States. It may be the case that the degree of downward rigidity of nominal
wages is a function of the rate of change in prices (Figure 4).
Let me now turn to Reinhart’s second proposition, on which I will comment inmore detail. Reinhart emphasizes the importance of managing expectations, particularly the commitment effect on long-term interest rates under the zero interest rate

210 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment

Figure 4 Nominal Wages and CPI Inflation

6
5

Percent
Total cash earnings
Core CPI

4
3
2
1
0
–1
–2
–3
1981 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03
Notes: 1. The total cash earnings and scheduled cash earnings are the percentagechanges from the previous year. The inflation rate is the percentage change
from the previous year in the overall CPI (adjusted for the April 1997
consumption tax increase).
2. The total cash earnings and scheduled cash earnings are per capita forworkplaces with at least 30 employees.
Sources: Ministry of Public Management, Home Affairs, Posts and Telecommunications,“Consumer Price Index”; Ministry of Health, Labour and Welfare, “Monthly
Labour Survey.”

environment, and I definitely agree with him. As you all know, the Bank of Japan (BOJ)
has made a commitment to continue with the quantitative easing policy until the yearon-year change in the CPI registers zero percent or higher on a sustainable basis. Thisis virtually the same as the commitment to continue with the zero interest rate policy,
and it is playing a very important role in the current phase of economic recovery.
Having said this, we should also be aware of the limits of the commitment effectas students of the “dismal science.”
First, the commitment effect depends very much on the economic conditions at thetime when the commitment is being made. In Japan, the risk-taking capability of bothbanks and firms has been declining as their capital position has been greatly impaired
since the bursting of the asset bubbles. In such circumstances, their sensitivity to
long-term interest rates has been weak, and the commitment effect tends to become
weaker than it would be otherwise. The room for long-term interest rates to come down
will be limited if the rates are already low at the time when the commitment is made.
Long-term interest rates in Japan have been at extremely low levels even compared withthose in the 1930s in the United States.
Second, some exogenous factors are necessary for the commitment to have an
impact on the economy. The economy will not be able to escape from deflation211

solely through lower long-term interest rates engineered by expectations management
if the interest rate elasticity of expenditure is low. This is particularly true in Japan in
the 1990s due to capital constraints, as shown in Table 1. When deflation is severe
and short-term interest rates are zero, market participants naturally anticipate thecontinuation of zero interest rates, and under such circumstances the commitment
to continue with the zero interest rate policy may not have an intrinsic effect. The
commitment will have an effect on the economy if the natural rate of interest begins
to rise due to some exogenous factors. In Japan, high growth in China and theeconomic recovery in the United States have contributed to the rise in the naturalrate of interest.
Table 1 Interest Rate Channel (+) versus Balance-Sheet Channel (–)
Sample period
Fiscal
1993–2000

Firms
With bond issues
Without bond issues

Interest rate
0.56
0.54

Contribution to I /K (–1) ratio
Firm’s balance sheet Bank’s balance sheet
–1.18
–0.26
–2.27

–2.09

Source: Nagahata and Sekine (2002).

As for the increase in bank reserves or the monetary base, its effect on the economy
seems to be rather limited. The BOJ has been substantially increasing liquidity interms of bank reserves and the monetary base since the start of quantitative easing.
However, as is shown in Figure 5, we have so far not observed the increase in themoney stock and the rise in prices.
The increase in reserves has produced various unintended and unfamiliar
phenomena. For example, since transaction costs have not been covered by shortterm interest rates, commercial banks have a greatly reduced incentive to maketransactions in the call market, and demand is raised for current account deposits at
the BOJ. As is shown in Figure 6, the outward shift of the supply of reserves has
been at least partially negated by the outward shift of demand. The outright purchaseof long-term government bonds has contributed to the increase in reserves. However,I am more skeptical than Reinhart about its impact on long-term interest rates
given our strong commitment. The BOJ has already made a credible commitment
regarding the future trajectory of short-term interest rates by announcing that it willcontinue with quantitative easing until the year-on-year change in the CPI registers
zero percent or higher on a sustainable basis. Given this credible commitment by
the central bank, we do not expect the outright purchase of long-term government
bonds to have an additional impact on long-term interest rates (see Baba et al. [2004]
for the details).
It is only recently that progress has been made in the academic research on deflation,and much more research is certainly necessary to draw any decisive conclusions.
In closing, I will make two comments that I think are important in terms of
future research on deflation. First, we must look into the cause of the problem moredeeply. When economists discuss the peril of deflation or how to combat deflation,
they naturally tend to form their views based on their own experience. However, thenature of deflation varies. To lump together the economies experiencing a negative

212 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment

Figure 5 Monetary Aggregates, Economic Activity, and Price Development[1] Changes from March 2001
700

Change from March 2001, percent

Changes from March 2001, percent

140

626.3 (left scale)120

600(right scale)

500

100
80

400
65.9
300

60

200

40

100

20

7.5

3.1

0

4.2

–100

0

–1.4

–8.4

–20

Current
Monetary
M2+CDsBank
Industrial Real GDP
CPI
accountbaselending
production
balance at
the BOJ(July 2004) (July 2004) (July 2004) (June 2004) (June 2004) (2004/I) (June 2004)[2] Development since 1990
3.0

1990/I = 1, seasonally adjusted
Monetary base
M2+CDsNominal GDP
Core CPI

2.8
2.6
2.4
2.2
2.0
1.8
1.6
1.4
1.2
1.0
0.8
1990

91

92

93

94

95

96

97

98

99

2000

01

02

03

04

Sources: Cabinet Office, “National Accounts”; Ministry of Public Management, Home Affairs, Posts
and Telecommunications, “Consumer Price Index”; Ministry of Economy, Trade andIndustry, “Indices of Industrial Production”; Bank of Japan, “Financial and Economic
Statistics Monthly.”213

Figure 6 Illustration of Reserve Market

Short-term
interest
rates

ReservesupplyReservedemand

BOJ increased thereserve supply

Bank reserves• Less incentive to trade in the call market• Negative yen funding cost for foreign banks

CPI inflation rate under the heading of deflation misses an important point. For
example, Japan’s stagnant economy is more the result of an asset price decline, rather
than a decline in the general price level.
Second, we must look into the incentive structure of private economic agents. For
example, a massive increase in liquidity together with capital constraints has created asomewhat unique situation that in turn affects the effectiveness of monetary policy(see Baba et al. [2004] for the details).
Although time does not permit me to say more along these lines, the Japaneseexperience seems to tell us that the current tools of economics are insufficient andmust be supplemented.

References

Akerlof, George A., William T. Dickens, and George L. Perry, “The Macroeconomics of Low
Inflation,” Brookings Papers on Economic Activity, 1, 1996, pp. 1–76.
Baba, Naohiko, Shinichi Nishioka, Nobuyuki Oda, Masaaki Shirakawa, Kazuo Ueda, and Hiroshi
Ugai, “Japan’s Deflation, Problems in the Financial System, and Monetary Policy,” BIS
Working Paper, Bank for International Settlements, 2004 (forthcoming).
Kuroda, Sachiko, and Isamu Yamamoto, “The Impact of Downward Nominal Wage Rigidity on the
Unemployment Rate: Quantitative Evidence from Japan,” Monetary and Economic Studies,21 (4), Institute for Monetary and Economic Studies, Bank of Japan, 2003, pp. 57–85.
Nagahata, Takashi, and Toshitaka Sekine, “The Effects of Monetary Policy on Firm Investment after
the Collapse of the Asset Price Bubble: An Investigation Using Japanese Micro Data,” Researchand Statistics Department Working Paper No. 02-3, Research and Statistics Department, Bankof Japan, 2002.

214 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

General Discussion

Okina, Kunio, and Shigenori Shiratsuka, “Asset Price Fluctuations, Structural Adjustments, and Sustained
Economic Growth: Lessons from Japan’s Experience since the Late 1980s,” Monetary andEconomic Studies, 22 (S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2004,
pp. 143–167 (this issue).

General Discussion
Responding to comments made by the discussants, Vincent R. Reinhart agreed with
Simon Price that high inflation could indicate government failure. He added that thismight be a reason behind the negative correlation between inflation and low economic
growth. Reinhart’s view on asset price deflation, an issue raised by Masaaki Shirakawa,
was that, in the presence of a zero bound constraint on nominal interest rates, thephenomena of asset price deflation and real interest rate increases should not be viewed
separately. Reinhart agreed with Shirakawa’s view on the effectiveness of quantitativeeasing, and admitted that it could have a limited impact in stimulating real economic
activity. Rather than relying on uncertain mechanisms, Reinhart’s preference was torely on a familiar instrument, i.e., a commitment to short-term nominal interest rates.
Reinhart also agreed with Shirakawa that structural impediments in the Japanese
economy magnified and prolonged the recession. Reinhart noted there were limits towhat a central bank can do to offset an aggregate demand shock, especially if the shock
is sudden and large.
Following this discussion, other participants raised a wide spectrum of issues.
Assaf Razin (Tel Aviv University and Cornell University) addressed the topic ofmonetary policy stances in a low-inflation environment. He agreed that low inflationin the 1990s was partly due to globalization, which likely reduced the monopolistic
power of firms via increased competition. Price objected that the level of inflation in
the long run was solely determined by a central bank’s monetary policy. Charles L.
Evans (Federal Reserve Bank of Chicago) pointed out that strong productivity growth,
to the extent of creating deflationary pressure, might also induce the nominal interest
rate to hit the zero bound. Stefan Gerlach (Hong Kong Monetary Authority) notedthat historical episodes of deflation were often associated with positive economic
growth. Etsuro Shioji (Yokohama National University) questioned whether monetary
policy responses to supply shocks in a low-inflation environment would be similar
to those in a mild-inflation one.
Reinhart responded that deflation would be a risk when it turned out to bepernicious, raising the real interest rate, and further weakening aggregate demand.
He further noted that if deflation were truly caused by a rapid increase in aggregate
supply, then the resultant high real interest rates would have far less impact than in
the case of a tremendous decline in aggregate demand. Finally, he stated that it is acentral bank’s responsibility to keep the price level stable, even in the face of rapid
productivity growth.
George A. Kahn (Federal Reserve Bank of Kansas City) noted that a commitment
to the future path of the monetary policy instrument was hard to achieve merely
through central bank communication. He also noted that such a commitment could215

tie the hands of a central bank in an undesirable manner in an uncertain economic
environment. Bennett T. McCallum (Carnegie Mellon University) commented that,when considering the future path of interest rates, the level of the steady-state
inflation rate would be crucial since it also governed the steady state of nominalinterest rates. Shigenori Shiratsuka (Bank of Japan) expressed the importance of acommitment effect, especially when the short-term nominal interest rate is close to
zero. He noted, however, that the theoretical basis underlying the commitment effectwas still in a developmental phase and voiced the need for more research in pursuit ofan empirically reliable mechanism.
Regarding the issue of inflation targeting, Gregory D. Hess (Claremont McKenna
College) questioned whether adoption of an inflation target alone would reduce thelikelihood of hitting the zero bound. Kahn commented that a credible commitment
to an inflation target could anchor expectations at a low positive level, which hesuggested was a better way to deal with zero bound problems. William R. Easterly(New York University) asked whether inaccurate inflation measures, mainly stemming from quality improvements, might affect the conduct of monetary policy.
Reinhart cautioned that an inflation target alone could not be a sufficient solution,
since the inflation target itself was silent about intermediate-term dynamics on how
to reach the target.
Regarding the quantitative easing policy adopted by the Bank of Japan (BOJ),
Jean-Philippe Cotis (Organisation for Economic Co-operation and Development)
pointed out that a massive liquidity provision might have prevented the cumulative
deflation scenario from occurring, and contributed to maintaining a mild-deflation
regime in Japan. Shirakawa mentioned that it was argued whether increases in thecurrent account balance at the BOJ had produced stimulative effects on output
and prices through various channels, such as achievement of zero interest rates,
stabilization of the financial system, and signals for the commitment duration ofzero interest rates. He then pointed out that the BOJ’s aggressive liquidity provision
played an important role in stabilizing financial markets. Philip W. Lowe (Reserve
Bank of Australia) asked whether a central bank’s direct financing of a government
budget deficit could be an effective channel as a more direct method for money
creation. Kazuo Ueda (Bank of Japan) replied that the BOJ was forbidden by law tounderwrite government budget deficits and further questioned the effectiveness ofsuch underwriting on theoretical grounds.
Hess commented on structural problems in the Japanese economy, notingthat deflation is often a structural issue for the real, banking, and financial sectors
rather than a monetary policy issue alone. Lowe added that a central bank should
be careful in monitoring a structural change that may occur even when inflation is
low and stable.

216 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004