Deflation, a demon from the distant past or a real danger now ?
During the summer of 2009, Belgium and the euro area, as well as other industrialised countries, recorded negative inflation rates. Although they were the direct result of sharply falling commodity prices in the second half of 2008, policy-makers and the general public wondered whether this would be the start of a deflationary spiral. Indeed, parallels with the Great Depression in the 1930s – which was also characterised by an asset price boom-bust cycle and banking stress – were drawn. The article explains why deflation can have dramatic consequences for the economy, gauges the current deflationary risks and discusses what the policy options are in a deflationary environment. In past centuries, deflation – when defined in a broad sense as a decline in the general price level – was a frequent phenomenon and was not always accompanied by economic hardship. When deflation is defined more narrowly as a sustained decline in the general price level that gives rise to further expected falls, it is no innocent phenomenon since it confronts an economy with a number of nominal rigidities which can trigger a deflationary spiral. One such rigidity is the lower bound on nominal interest rates which can limit the central bank’s potential to stimulate the economy as real interest rates cannot fall any further. Second, the real burden of outstanding debt increases when prices fall, leading to a redistribution of wealth towards lenders who generally have a lower propensity to consume than borrowers. Third, because of money illusion, it is difficult to cut nominal wages, making the adjustment of real wages to a worsened economic situation difficult or even impossible. As shown by available indicators, risk of deflation in the euro area seems limited. The observed negative inflation rates are not a sign of widespread price falls. Inflation expectations remain in check although inflation is expected to return rather slowly to levels consistent with price stability. Taking a broader view, the IMF deflation vulnerability indicator, which combines a range of macroeconomic indicators, shows an increased risk of deflation in all industrialised countries. Having a quantitative definition of price stability that defines the latter as a low, but strictly positive rate of inflation – as the Eurosystem has –, helps to prevent deflation. Yet, when confronted with a deflationary threat, monetary policy has a range of tools to tackle deflationary risks. First, nominal policy rates can be lowered aggressively, until they hit the lower bound. If further stimulus is warranted after rates have been brought close to zero, central banks can resort to unconventional monetary policies, as they have done in previous months. Also fiscal policies can help to contain deflationary risks, especially to tackle banks’ solvency problems if they threaten financial stability, provided that the longer-term sustainability of public finances remains intact. Finally, it must be emphasised that policy-makers have to decide on appropriate policies to deal with deflationary risks in real time.
Volume (Year): (2009)
Issue (Month): III (September)
|Contact details of provider:|| Postal: |
Phone: (+ 32) (0) 2 221 25 34
Fax: (+ 32) (0) 2 221 31 62
Web page: http://www.nbb.be/
More information through EDIRC
When requesting a correction, please mention this item's handle: RePEc:nbb:ecrart:y:2009:m:september:i:iii:p:7-31. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.