Ben Broadbent: The economics of deflation
Speech by Mr Ben Broadbent, Deputy Governor for Monetary Policy of the Bank of England,
at Imperial College Business School, London, 27 March 2015.
* * *
The CPI in February this year was no higher than in February 2014. This is the first time the
UK has failed to record positive annual inflation for over 50 years. Inflation was briefly
negative in late 1959 and early 1960. Before then, you have to go back to the early 1930s,
and the agonies of the Great Depression, to find a period when UK consumer prices fell over
a sustained period (Chart 1 plots three-year rolling averages of inflation). Because of the
depth of the economic downturn at that time, and the more recent stagnation of Japan, the
weakness of price inflation today has raised fears in some quarters about the risks of
sustained deflation in this country.
The MPC's objective is not simply to prevent prices from falling: it is to ensure they rise at the
target rate of 2% a year. Because of the attention it's been getting, however, I'm going to
focus today on negative inflation specifically. I'll divide the substance of my remarks in two.
One part will discuss the basic economics - how and why it matters if prices decline over a
protracted period - the other, the frequency and implications of deflation in the historical
data.
Within that first section there are two
Chart 1 Deflation last seen in 1930s
points I'll try and get across. One is the
distinction between the price of what we
buy (consumer prices) and the price of
what we sell (mainly wages). For the
moment it's the first that's fallen not the
second: the drop in inflation has been
driven largely by something that has
significantly boosted real incomes (the
sharp decline in commodity prices). It is
what some have termed "good" deflation
and, while it is unlikely to go on for that
long, it is positive, not negative, for
demand and output.
There is a risk that the fall in prices
becomes more generalised and more
sustained. If so - and this is the second
point about the economics - what
Source: ONS and Hills,Thomas, Dimsdale (2010). matters is not deflation per se but the
capacity of monetary policy to respond
to it.
There are circumstances, in particular when the appropriate or "neutral" real interest rate is
clearly positive, and when it's not entirely unexpected, in which mild deflation wouldn't pose a
problem. I think Britain was in precisely that position for much of the classical gold standard
period, during the second half of the 19th century (you can see from Chart 1 that periods of
deflation were common at that time; as we shall see, they didn't appear especially damaging
for output growth). Deflation becomes a problem if, in conjunction with the zero lower bound
on nominal interest rates, it prevents the monetary authority from setting a real short rate
that's sufficiently low to ensure stable growth.
Following the financial crisis, of course, the developed world has been in exactly that
position: the neutral real rate of interest has been extremely depressed, official interest rates
have been pushed to the zero lower bound and central banks have employed unconventional
means of easing monetary policy. Were it to occur right now, sustained deflation would
therefore pose more of a risk than at times when the neutral real rate was higher.
But, in my view, those risks are nonetheless relatively contained. For one thing I think the
evidence suggests that unconventional policy is effective: even if they don't circumvent it
entirely, asset purchases help soften the constraint of the zero lower bound. Second, with the
financial system gradually improving my guess is that the neutral real rate of interest is more
likely to rise than fall over the next couple of years. Third, and most importantly, I think the
chances of a sustained and widespread deflation are in any case low.
That's certainly what the international experience suggests. That experience is substantial:
we have annual CPI data since 1960 for over 70 countries, a total of over 3,000 data points.
In only 70 cases (barely 2% of the sample) have consumer prices actually fallen and in the
majority of those inflation was positive the following year. Of the 24 instances in which prices
have fallen for more than one year, all but four - two in Japan, two in Bahrain - have
occurred in developing countries with pegged exchange rates. In fact, there's a general
tendency for changes in inflation to be more persistent when the exchange rate is fixed. At
least when policy has a degree of credibility, deviations of inflation tend to peter out relatively
rapidly in countries with independent monetary policies.
In part this may reflect precisely the freedom to ease policy that, if it's not ruled out by an
exchange rate peg, may nonetheless be compromised by the zero lower bound. At least until
it began to conduct QE, almost a decade after the economy began to turn down, Japan was
clearly in this position. But I suspect it's also because, when there's an independent and
credible policy, the risk that inflation expectations become "de-anchored" from any target is
lower to begin with.
As I say, for us that target is 2%, not zero. Even if the current undershoot is due mostly to the
effect on the level of the CPI of the sharp drop in commodity prices, and should therefore
have only passing effects on its rate of growth, our central expectation is that inflation will still
be below target in a year's time. All else equal, we probably need to see not just stable prices
of commodities and other tradable goods if we're to meet the target over a reasonable
horizon, but some further acceleration in domestic costs as well. While that's what the central
forecast in the February Inflation Report entails, the MPC will obviously have to be watchful,
in the meantime, for signs that "good" deflation is turning into something worse.
But we should not over-state the risks.
The costs of deflation: income and interest rates matter too
Something one hears quite often is that deflation is a problem "because it encourages people
to postpone consumption". Deflation - or more precisely the expectation that prices will fall -
therefore weakens demand, it is said, and this can lead to a vicious circle in which prices are
then depressed further.
As far as it goes this has some truth to it. But it's at best a partial description of the problem,
at worst a bit misleading. It leaves out two important considerations.
One is nominal income. Suppose you're told that prices will fall over the next year but that
the value of your income will remain unchanged. All else equal, the prospect of falling prices
will give you an incentive to save more of your income (i.e. to postpone a bit of consumption).
At the same time, the real value of that income will prospectively have risen. On most
estimates of the various sensitivities the second effect will dominate the first and
consumption should actually rise1, even before those price cuts actually arrive.
Conversely, if all prices fall simultaneously, including the price of labour (the nominal wage),
then there's no boost to real income to offset any increased tendency to save. Not only that,
falls in nominal income would also expose the economy to a potentially much more serious
risk, namely a rising burden of debt. Because the principal is fixed in nominal terms,
shortfalls in cash income make debts harder to service, increasing the risk of financial
instability and the pressure on debtors to cut back spending. It's this "debt deflation" channel,
emphasised originally by Irving Fisher and studied in depth by Ben Bernanke, amongst
others, that is thought to have been the main cost of falling prices and wages during the
Great Depression. It's therefore important to understand whether "deflation" is happening
simply because there's been a sharp drop in the price of something we buy - oil, say - or
whether it's a more generalised phenomenon in which nominal incomes too are falling.
The other important factor is interest rates. The incentive to save depends not on inflation
expectations per se but on the (ex ante) real rate of interest. As long as nominal interest
rates are higher than inflation - and that's been the case through history, more often than not
- foregoing £1 of spending today buys you more than £1's worth of spending tomorrow. So
this "postponement" effect doesn't suddenly appear when expected inflation dips below zero:
it's always there, to varying degrees, and depends on the extent to which expected inflation
lies below the nominal rate of interest, i.e. the real interest rate.
Indeed, it's partly by tweaking this incentive to save, via the short-term real rate, that
monetary policy is in theory supposed to work. If confidence in the future suddenly declines,
for example - something that would on its own tend to push up rates of saving - the central
bank will tend to react by lowering interest rates and pushing back in the opposite direction,
in order to sustain demand. The appropriate real interest rate will therefore change over time.
And the relevant question, in this context, is not so much whether people expect any sort of
deflation, but whether they expect it at a pace that exceeds whatever is the appropriate real
interest rate at the time2. If that were to happen, policy would run into the zero lower bound
for nominal rates and central banks will find themselves reaching for unconventional policy
tools.
Similarly, debt dynamics are driven not by nominal income growth in isolation but how that
growth compares with nominal interest rates3. If the two fall rise and fall together - to the
extent nominal interest rates can accommodate movements in nominal income growth -
there's no impact on debt accumulation: whatever proportion of income was needed to
service debts beforehand is sufficient after the fact. It's when income growth falls a lot further
1
Economists call the sensitivity of consumption to a change in its relative price over time the "inter-temporal
elasticity". That coefficient is poorly measured in the data but usually found to be relatively small and
significantly less than one. At the same time, a permanent gain in real income should, even it's expected to
arrive only a year from now, prompt an immediate and almost one-for-one response of spending today. So, at
least in principle, the positive "income effect" of a prospective drop in prices - holding fixed nominal pay -
should be expected to outstrip the negative "inter-temporal substitution effect".
2
If the appropriate real rate is r* then the central bank would ideally want to set a nominal rate of r*+ πe, where
the second term is inflation expectations. But nominal rates can't be lower than zero - or whatever number,
close to zero, constitutes the effective lower bound - so if r*+ πe < 0 the actual real rate will be higher than it
should be. Note that this can happen either if πe is well below zero or if, as has been the case since the crisis,
the same happens to r*.
3
If b is the ratio of debt to income then its growth rate is given by r - g - s/b, where r is the ex post interest
rate, g the growth rate of income and s the proportion of income used to pay off debt. So if g falls and r does
not either debt starts rising faster than income or debtors must save more; if r and g change by the same
magnitude b and s don't have to.
than the interest rate, and therefore when servicing debts requires much more of their
incomes than people had expected, that problems can arise4.
When (mild) deflation doesn't matter: a high neutral real rate
I think you can see the importance of these considerations in the UK, both in recent history
and, as it happens, over a much more distant period.
In the second half of the 19th century, and up until the First World War, Britain and much of
the advanced world were on the Gold Standard: the price of gold was fixed at £3.83/oz.
Deflation was commonplace. Discoveries of gold occurred only intermittently, and because
the global economy - and therefore the demand for currency - was generally expanding, its
real price often came under upward pressure. With the nominal price fixed, the only way that
could happen is if the denominator of that real price - the price of goods and services -
declined. Thus UK consumer prices fell significantly during the 1840s, for example, and
again in the late 1850s; they also fell through the 1880s (Chart 2). And although real pay
tended to grow over time, these deflations were sometimes severe enough to mean that
nominal wages declined.
However, there's no evidence this had an
Chart 2 Deflations common during Gold
especially severe effect on the economy.
Standard
To be sure, lower inflation was associated
with weaker GDP growth, lower wage
growth with higher unemployment (Charts
3 and 4). But there doesn't look to be
anything particularly bad about negative
inflation: as far as one can tell, the
economic cost of moving from of zero to
-1% (say), whether in price or wage
space, wasn't any worse than that
involved in going from 5% to 4% (for
example5).
One reason for this may be that people
were adapted to the regime - they were
used to the idea that prices, and even
nominal wages, occasionally declined, and
because these things were therefore more
flexible, it didn't take an especially severe
Source: ONS and Hills,Thomas, Dimsdale (2010).
recession to get that to happen.
Chart 3 Those deflations no more costly than Chart 4 ...same was true for wage growth
other disinflations...
Source: ONS and Hills,Thomas, Dimsdale (2010). Source: ONS and Hills,Thomas, Dimsdale (2010).
Chart 5 Interest rate unconstrained But what must also have been important, it
by zero bound seems to me, is that the appropriate level of
real interest rates was sufficiently high
through the period that monetary policy
never had to contend with the zero lower
bound on the nominal rate6. Chart 5 adds to
Chart 2 the series for Bank Rate, in green.
The real short-term interest rate - which we
know, after the event, can't have deviated
that much from the level necessary to
sustain stable growth and prices (since
that's what generally occurred) - averaged
4% between 1850 and 1914. If the neutral
real rate is anything like that high, only a
very severe deflation would drag the
appropriate nominal rate close to zero. As it
was, Bank Rate was unconstrained from
responding to lower nominal growth7, when
that occurred, and never fell below 2%.
Source: ONS and Hills,Thomas, Dimsdale (2010).
Perhaps the authorities of the time were just lucky not to have run into the zero lower bound.
But I think this episode illustrates that even protracted declines in prices needn't be
especially costly if, for whatever reason, the appropriate real interest rate is relatively high.
Sustained deflation more costly when interest rates close to the lower bound
Clearly, we are not in the same position today. Cuts in interest rates after the financial crisis
were crucial in preventing a much worse downturn. They depressed the real short rate,
softening what might otherwise have been a steeper rise in the saving rate. Matching the
decline in productivity and income growth (Chart 6), the resulting falls in household interest
rates meant deleveraging could occur without a big jump in gross debt repayments8. Net of
interest payments, growth of nominal incomes has been little different over the past six years
than it was in the pre-crisis decade (Chart 7).
But balance sheets and gross debts are clearly far larger now than in the late 19th century.
Productivity and real income growth have been significantly lower and, partly for that reason,
the neutral real interest rate fell steeply after the crisis and almost certainly into appreciably
negative territory. So even without deflation, central banks have found themselves up against
the zero lower bound and compelled to employ unconventional policy tools. As a result, there
is now less room to deal with any entrenched and protracted deflation, in prices and wages
alike, should that occur.
Chart 6 Spread between nominal interest Chart 7 Net of interest payments, nominal
rates, income growth broadly stable income growth little changed since crisis
Source: ONS.
Source: ONS.
A good disinflation so far...
What are the chances of such a thing? Certainly what we've had in the past few months
doesn't qualify. In fact, it's been a largely positive story, because the fall in inflation has been
driven not by the declining value of what we sell, including wages - though weak by
precrisis standards, nominal income growth has actually risen slightly of late - but by a steep fall
in the real price of something we buy9. This therefore counts as what the economist Michael
Bordo calls a "good" disinflation, driven by an improvement in productivity or (as in this case)
the terms of trade. In the year to 2014Q4 real per capita disposable income grew at its
fastest rate for seven years; real income growth is likely to have picked up further in 2015Q1
(Chart 8).
There is evidence this has already fed through to spending and to household confidence.
Real household consumption too rose at its fastest pace for seven years during the course of
2014. And this occurred despite a marked decline in survey measures of households'
nearterm inflation expectations (Chart 9) - little evidence here that weaker inflation expectations
delay or depress consumer spending.
Chart 8 Drop in commodity prices has Chart 9 Financial market measures of
boosted real per capita income inflation expectations close to average
Source: Source: Bank of England, Barclays Capital
Source: ONS; ex income from and consumption of imputed
rents.
In truth, I don't think we should be terribly surprised by this. Theory says households will
raise consumption one-for-one with any increase in the level of real income deemed to be
permanent. In practice people may take time to react to real income shocks; it's also possible
they expect some of the recent declines in energy prices to be reversed10. But, in the data,
there's no correlation between household saving rates and changes in real energy prices,
either here or elsewhere in the OECD11. This suggests their effects on income are in general
matched by equivalent shifts in real spending. Note that the UK is not the only place where
consumer confidence has risen in recent months (Chart 10).
Nor is it unusual to see stronger demand at a time when these survey measures of
household inflation expectations are falling. Typically, these near-term expectations surveys
track actual inflation12. And quite a bit of the high-frequency variation in the CPI arises from
things that don't directly affect nominal pay - taxes and import prices, for example - but do
affect its real value. When taxes or import prices go down, real incomes rise (and
viceversa). This produces a negative near-term correlation between inflation and real income
growth; controlling for nominal pay, there is also a clear negative correlation between
surveyed inflation expectations and household optimism (Chart 11).
Chart 10 Consumer confidence has Chart 11 Surveyed household inflation
strengthened in US, Euro area expectations, optimism negatively
correlated
Source: European Commission, Conference Board
Source: ONS, Gfk/EC, Barclays Capital.
Note: * after controlling for current wage growth.
These results might give one pause about whether the "delayed consumption" channel really
is that important, or whether the surveys of inflation expectations are really telling you about
what matters. The link between consumption and real interest rates is not an empirically
strong one13. Other measures of inflation expectations - for example from financial markets -
are less depressed (Chart 9). A recent study using US data found that, even controlling for
nominal income, there was no correlation across individuals between their reported
expectations of inflation and spending14. At the very least, the results are a reminder not to
consider current inflation or survey measures of household inflation expectations on their
own, but in the context of what's happening to incomes and interest rates.
International experience: proper deflations are rare, especially in countries with
floating currencies
That doesn't mean we can rest entirely easy. In particular, it would be wrong blithely to
assume that positive nominal income growth will continue, come what may. Deflations have
to start somewhere and there is a risk that falling prices will beget yet weaker or even
negative wage growth - that today's "good" deflation will metastasise into something a good
deal worse. Bordo classifies "bad" disinflations as those that coincide with recessions, "ugly"
episodes as steep and generalised falls in nominal quantities, all the uglier in the presence of
large gross debts.
However, my own view is that the chances of such an outcome are relatively low. I say that
partly because base effects will naturally give a big positive impetus to annual inflation in
early 2016. "Core" inflation is still running at over 1% and, barring another steep decline in
food and energy prices over the next year, headline inflation is likely to rise quite steeply in
early 2016.
I'm also struck by the rarity of persistent deflation in the past15, particularly amongst countries
with an independent monetary policy. As we've seen, long periods of falling prices were
perfectly common during the Gold Standard. That's inevitable under a commodity peg if, over
any period of time, the commodity itself is in fixed supply. The same was true in other
countries at the time and, infamously, during the Great Depression. It was only when Britain
came off gold, in 1931, that its nominal income started to accelerate16.
And since the Second World War, and the abandonment of commodity standards, positive
inflation has been the norm - so much so, in fact, that the commonly cited example of the
Japanese deflation is almost unique.
Chart 12a Deflation episodes are rare Chart 12b Even rarer in countries with
floating exchange rates
Source: Bordo and Eichengreen, IMF and OECD Source: Bordo and Eichengreen, IMF and OECD
Note: Sample 1960-2010; 3300 observations Note: Sample 1960-2010; 3300 observations.
The international data on consumer prices are relatively rich: we have annual numbers for
over 70 countries, most of them back to 196017. In all, across countries and years, there are
3,300 separate post-war observations. In only 70 of these - barely 2% of the sample - has
inflation actually been negative (Chart 12a); the majority of these "deflations" (46 out of 70)
have lasted no more than a year, many of these shorter episodes coinciding with falls in oil
prices; of the 24 deflations lasting two or more years, 20 have been in economies with fixed
exchange rates, most of those emerging economies; among countries with freely floating
exchange rates, only Bahrain and - somewhat more famously - Japan have experienced
protracted deflations, both of them twice (Chart 12b). This is not a common occurrence.
A credible monetary policy reduces the persistence of movements in inflation
Why might deflations be rarer in countries with floating exchange rates, and in emerging
economies, and should this provide any reassurance today? Yes, I think - to a degree.
One plausible reason for this pattern is that countries with fixed exchange rates give up
autonomy to control their own rate of inflation. Instead, domestic inflation is determined by
(i) inflation in the country to which their exchange rate has been fixed (most often the US)
and (ii) forces affecting their real exchange rate. Those forces are often important in
emerging markets: their terms of trade move around more and they are also subject to more
volatile financial flows than developed countries. Shocks that would tend to depress the
nominal exchange rate, were it free to fall - a drop in the terms of trade, for example, or
heightened risk aversion and capital flight - instead show up as negative inflation18.
It's not just the volatility that's higher, however: it turns out that shocks to inflation are also
more persistent in countries with fixed exchange rates (Chart 13; see also Monacelli and Gali
(2005)). And while this may simply reflect the particular disturbances affecting the equilibrium
real exchange rate - perhaps they play out only over time - it's also possible that the
persistence of inflation owes something to the lack of a stable domestic objective for
monetary policy.
In our theories, wage and price-setting are forward looking: high (low) expectations of
inflation over the future drag up (depress) actual inflation today. That's precisely why central
banks concern themselves with the stability of inflation expectations. It's also why a credible
inflation target is to some degree self-regulating. If people expect inflation generally to be on
target, over the medium term, the central bank has to do less actively to ensure it. Notably,
the persistence of movements in UK inflation fell sharply after the introduction of inflation
targeting in 1992 (Chart 14). To the extent this reflects improved credibility it implies less of a
need for policy to respond to one-off hits to the price level.
Chart 13 Inflation more persistent under Chart 14 UK inflation persistence fell after
fixed exchange rates introduction of inflation targeting
Estimated coefficient in regression of UK inflation
on lagged inflation, 20 year rolling window
1.6
Consumption deflator
1.2
GDP deflator
0.8
0.4
0.0
1962 1972 1982 1992 2002 2012
Source: Bordo and Eichengreen (1999), IMF and OECD.
Note: Blue shaded area represents +/- 2SD around diamond Source: ONS and Hills, Thomas, Dimsdale (2010).
central estimate of a panel regression; sample 1960-2010.
Conclusion: policy should be flexible but don't over-react to low inflation
We've heard a lot about the risk that deflationary expectations persuade people to defer
spending. We'll no doubt hear it again if inflation were to dip below zero over the next couple
of months. But it's at best a partial point. All else equal, the incentive to save depends not on
inflation expectations per se but on how far away they are from the nominal interest rate, i.e.
the real interest rate. By any measure - even if you use the near-term household surveys as
measure of inflation expectations - the real rate is extremely low, and still negative
(Chart 15). The extensive empirical evidence for this "inter-temporal substitution" channel is
in any case relatively weak - as the Governor pointed out recently, the more important
threat, particularly in developed economies with large balance sheets, is debt deflation. And
in that regard, it's the gap between interest rates and nominal income growth that matters.
Notably, nominal income growth has not declined of late.
Real interest rates still need to be low. Our inflation target is 2% not zero: what makes the
current position "good" is not low inflation per se but the fact that, in this particular instance,
it's been caused by something (a drop in oil prices) that improves real incomes. Even though
the direct effect of that decline will drop out of the annual comparison later this year and in
early 2016, there's a risk that, by depressing wage growth, sub-target inflation could persist
for longer than we expect.
More fundamentally, as I sought to
Chart 15 Real interest rates are low
explain in a recent speech, the
"neutral" interest rate consistent with
stable growth and inflation seems to
have fallen significantly over the
years, both before and since the
financial crisis. That's why, even
without deflationary expectations,
central banks came up against the
zero lower bound for interest rates.
And it's that zero bound that ultimately
makes deflations costly.
Source: BOE, Barclays Capital and own calculations.
My own view, however, is that the likelihood of a broad and protracted deflation, afflicting
wages as well as prices, is pretty low. The evidence suggests that asset purchases positively
affect nominal growth - they may not by-pass the lower bound on interest rates but they
certainly soften it. My guess is that, with the financial system improving, and signs that the
worst fears about the global economy may be subsiding, the neutral real interest rate is more
likely to rise than fall over the next couple of years. Over that period, headline inflation will
get a sizeable kick upwards, once the falls in food and energy prices drop out of the annual
comparison. In the meantime, the UK labour market continues to tighten - low inflation won't
be the only influence on pay growth this year - and the boost imparted by lower commodity
prices to real incomes is already apparent in higher consumer spending, here and in other
countries too.
Finally, history tells us these episodes are rare - rare, in the case of developed countries
with floating exchange rates, almost to the point of uniqueness.
Thank you.
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13
BIS central bankers' speeches