glenn stevens : inflation, deflation and all that speech by mr glenn stevens, deputy governor of the reserve bank of australia, to australian business economists 2002 forecasting conference dinner, sydney, 4 december 2002. * * * introduction in the formative years of the current generation of economists, inflation was considered to be one of the most pressing macroeconomic problems. that's not surprising, since most of the net rise in prices that has occurred in human history took place between the late 1940s and about 1990, as a plot of any price index in any industrial country would show. in australia's case, it was observable during the 1950s that, in periods of business cycle downturn, prices stopped rising but didn't actually fall. this was in contrast to the pre - world war ii experience, where price levels did fall during recessions. by the second half of the 1960s, it was even clearer that the price level had acquired a persistent upward trend, and around that time it became normal to look at the price level in its first difference form ( i. e. the inflation rate ) rather than its level. as all of us here remember only too well, inflation reached nearly 20 per cent during the mid 1970s. thereafter polices aimed at reducing it, with mixed success at first, but more lasting success in the aftermath of the early - 1990s downturn. a number of other countries had more clearly broken the back of serious inflation in the early 1980s ; we took a little longer. but in general it could be said that the period of really serious inflation in the western world lasted from the late 1960s until the early 1990s. the subsequent decade has been a period of low inflation almost everywhere. most recently, with a global business cycle downturn, inflation globally has declined further, and is currently low to very low in most places. so it is natural to ask whether, after a generation worrying about inflation, we might be faced with deflation. certainly the word'deflation'is used with much greater frequency than it has been for a long time. its use usually conjures up some vague notion of the great depression, which was the last time a widespread deflation occurred. so it is worth examining this in more detail. i want first to be clear what we mean by deflation, then to ask whether it is in fact occurring. then i want to ask whether we should worry about it, and if so, what we might do to counter it. as a

occurring, and adjust their behaviour accordingly. but adjusting incomes downward for deflation is typically harder to do than adjusting them upwards for inflation. so percentage point for percentage point, deflation is arguably a bit more painful than inflation. harmful deflation typically occurs in parallel to developments in prices for assets and balance sheets. this is usually in the aftermath of a boom accommodated by a big run up in debt, involving a large increase in capacity in response to very optimistic expectations about future sales and profits. when the optimistic expectations cannot be met, it is apparent that firms are over - invested and overleveraged. they are then under pressure to shore up their balance sheets. asset prices fall, as firms seek to disinvest. banks and other lenders find that the quality of their assets has deteriorated, and are tempted to reduce the flow of new credit in order to conserve their own capital. aggregate demand in the economy declines, and prices for goods and services fall. this is the'debt deflation'described by irving fisher many years ago. depending on the size of the preceding boom, and on the policies pursued during the bust, this process can be exceedingly painful. in the case where expectations of ongoing deflation become strongly held, moreover, it is possible that some fairly serious problems of economic management can emerge. expectations that prices will continually fall may lead people to postpone spending, which of course amplifies the deflationary pressure. the rate of deflation might, in extreme circumstances, also mean that attempts to boost growth by reducing interest rates run into the problem that the nominal interest rate cannot fall below zero, which might mean that the real interest rate is too high for the economy's needs. i return to this below. 2. is deflation happening? might it happen more widely? deflation is certainly not happening in australia. for the year just past, the cpi rose by about 3 per cent. underlying measures rose slightly less than that. about 70 per cent of the items in the cpi basket recorded increases, while 30 per cent of them fell, which as i noted above is fairly typical of the experience of the past decade. in the part of the economy where prices are determined by market forces ( as opposed to being subject to direct influence of government ), prices for goods rose by about 2 per cent, while prices for services rose by nearly 5 per cent. in the period ahead, our forecast is that inflation will continue to be about where it is now