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Monday, November 11, 2002

Cecchetti Plays Down Deflation Fears

Stephen Cecchetti in an article in this morning's Financial Times attempts to persuade us that deflation fears are overdone. Cecchetti is a serious economist and his arguments bear consideration, so what are they? He differentiates between falling prices in one or more sectors, and a generalised decline in prices, only the latter, clearly, constitutes deflation.

Deflation is when prices are falling on average, not when some prices rise and some fall. The objective of most central banks is to stabilise prices on average, which means that some prices will be falling while others are rising.People running the companies whose product prices are falling are not going to be happy about this. They are going to whine that something needs to be done about this "deflation".

This is generally true, although it isn't necessarily true that the relevant companies will necessarily 'whine'. It is important to differentiate here between sectors such as technology where a decline in prices can produce (depending on elasticities) rising revenues and profits, and declining industries (like steel) or agriculture and raw materials where declining world prices produce discomfort in some sectors. There are non-monetary solutions available for this latter class of problems like protectionism and subsidies (both currently practised by the Bush administration), although whether these are adviseable or desireable is another matter. as Cecchetti indicates since the CPI is an average some prices will always be always be rising less than the inflation level. Logically then , as this level approaches zero, some prices must be declining. So where is the worry, well:

As long as central banks do not allow sustained, steady deflation, we shall be fine. After decades of suffering from inflation of 5-10 per cent, we are now close to price stability. Let us congratulate policymakers for providing the foundations for stable long-term growth.

OK, fine. But before we start cracking open the champagne and congratulating our politicians central bankers, perhaps we might stop to consider the 'as lomg as.....' caveat. Because isn't that just the problem, isn't this what those who are worried about inflation Krugman, De Long, Roach (yours truly) are worried about, that we might drift into sustained, steady deflation (I think we understand the difference from sectoral problems and the statistical properties of an average, thanks. Oh, and by the way we are 'preoccupied', not 'whining' - isn't this what dogs do, there's really something I find disagreeable in the use of this metaphor). So what is the explanation of why this sustained, steady deflation is unlikely:

Related to these deflation fears is concern that monetary policy has become ineffective. People maintain that interest rate cuts no longer have the impact they once did and that, with the federal funds rate at 1.25 per cent, the Federal Reserve is going to run out of ammunition pretty soon. I do not believe either argument. Monetary policy has always acted through corporate investment, consumer borrowing and the current account and it still does .......generally they [these effects] are alive and well.

I'm sorry, this argument doesn't convince, corporate investment is moving to China, and (perhaps) in the case of services to India, consumer borrowing is growing alright, but the negative effects of this on the current account is only to clear. Most notably the dollar isn't adjusting sharply to compensate. The big question then is, why is this? Here Cecchetti is silent, since clearly the explanation needs to be looked for globally, and it is here that the limitations of a US centric, 'business as usual' approach are most apparent. The dollar is not falling anywhere far, fast, because there is no-one else about to go up. This is the force of Roach's points about the lack of a rival growth engine to pull the train, and the global character of the deflationary headwinds (strangely, now I think of it, the word globalisation doesn't appear anywhere in the article. Perhaps this is why he things the traditional monetary effects are alive and well, although in fact many of the 'changes in the system of financial intermediation ... that allow many borrowers to bypass conventional banks' (and which are his specialist area) are among the processes most affected by globalisation.

Going back to the current account problem. One traditional response would be to lower interest rates to drive down the currency. But wait a minute, interest rates are already at 1.25%:

What about the zero nominal interest-rate floor, the point at which central banks supposedly become impotent? Listening to officials from the Bank of Japan, you would think that once they set their interest rate target to zero, there was nothing else they could do about stagnant growth and falling prices. Again, I do not believe it. We all know that whatever a central bank does, it does it by adjusting its balance sheet - buying and selling securities and making loans to commercial banks. And, uniquely, the central bank can expand its balance sheet without limit. None of this changes when the nominal interest rate hits zero. Monetary policymakers can still buy securities, enlarging their balance sheet, increasing the amount of money in the economy and eventually driving prices up. These "unorthodox" methods are not all that mysterious. Federal Reserve policymakers know how they work and will use them decisively if and when the time comes.

Again, everything seems fine, except that, well listening to Cecchetti you would think that once the BOJ had set their target rates to zero, then they had done nothing else about stagnant growth and falling prices, you would think they hadn't thought about adjusting their balance sheet - buying and selling securities and making loans to commercial banks. Listening to Cecchetti you would think they hadn't done any of this, but you wouldn't be right. On this topic I'm afraid Cecchetti is simply ignorant, and is showing his ignorance in public. If this is meant to re-assure, then I'm afraid it might have the opposite effect. In fact the BoJ has been systematically raising it's monthly rinban buying operation of Japanese Government Bonds (JGBs) from ¥400 billion to ¥600 billion to the current ¥1000 billion (a figure which may be about to go up again sometime soon). And again Cecchetti is wrong, the central bank cannot simply 'expand its balance sheet without limit' as the Japanese have discovered to their cost: the ratings agencies start downgrading you. Ignorance about Japan is perhaps our main enemy right now, so I'll take the liberty of quoting Morgan Stanley's Japan commentator Takehiro Sato at some length:

We had thought the BoJ held a monopoly on "ZIRP" (Zero Interest Rate Policy), but the FRB rate cut on November 6 suggests that macro policy globally may be heading into the "World According to ZIRP." The Japanese economy can be viewed as the front runner in a global deflation race with no apparent end. The central banks of other industrialized economies will gradually come to understand the BoJ’s struggle, having completely exhausted traditional policy measures. Central banks fought inflation through the mid-1990s, but the battleground has changed to the uncharted territory of deflation. In some respects, it is positive that overseas policy authorities and academics will begin coming to terms with the tough challenges of fighting deflation in a ZIRP environment, which is something that only Japan has experienced until now. The BoJ should benefit from overseas financial authorities giving serious consideration to the implications of a "purposeless" policy of quantitative easing (basically a zero interest rate with a ¥15-20 trillion reserve floor) should the FRB and ECB move into the ZIRP realm. The unfavorable scenario for the BoJ would be foreign central banks having unexpected success with quantitative easing and such easing ironically spurring a recovery for the global economy. In this case, the BoJ is likely to face criticism for being slow on the draw with policy action.

Japan’s experience thus far suggests slim chances for the latter scenario. Once the policy rate drops into the lower 1% range, the game is already over for monetary policy. While monetary policy can be effective in restricting total demand when necessary, it lacks the wherewithal for demand creation. Since the elasticity of real money demand from nominal rate fluctuations rises to an extreme level with a zero interest rate, the short-term money market endlessly absorbs liquidity supplied by the central bank, just like spraying water in a desert. Liquidity never makes it to the real economy. This can also be understood in terms of zero opportunity costs for reserve deposits. There is no pain from holding an infinite amount of reserves ("no pain, no gain"). Additionally, the BoJ has gradually raised its liquidity provision mechanism of Rinban operations (which is equivalent to coupon pass). However, these operations wind up strengthening flattening bias on the yield curve, and actually contribute to deflation expectations through the financial market’s expectation formation dynamic. ZIRP poses the danger of getting caught in a policy trap that cannot be easily escaped. Other central banks should give careful consideration to the siren call of ZIRP.

In retrospect, efforts in 1995 to reenergize markets by taking stronger-than-expected additional monetary easing were a significant milestone on the road to ZIRP. In fact, the economy itself, and not only financial markets, shifted from inflation to deflation expectations from 1995. Data for various key macro parameters, such as relationships between short-term rates and the long-term/short-term rate spread and the current account surplus and long-term rates, show a major dislocation occurring in 1995. Nearly two and a half years have passed since the IT bubble collapsed (around 10 quarters), and the US is approaching the point at which the deflation impact from Japan’s stock price collapse started to manifest itself in the real economy.
Source: Morgan Stanley Global Economic Forum

The argument which Saito presents and which Cecchetti ignores is that of expectations. You see, it seems the deflation turning point comes when consumer and corporate expectations shift to a deflationary scenario, then it becomes logical to postpone both investment and consumption decisions, thus giving traction to an environment of secular deflation which may prove extremely difficult to pull out of, especially if the deflation turns global. This postponment can give rise to a situation where an economy's productivity grows more rapidly than growth in the real economy on a sustained basis, the so-called output-gap scenario. Unfortunately Cecchetti does not let us know his feelings on these arguments, and since they are among the most forceful explanations as to why the deflation danger may be real, they certainly merit consideration.

As to why all this might be happening, there is an almost total silence. Regular readers of this column will know I have tried to spell out three factors which may help understand why we have a global deflation watch call out right now. Firstly is the 'industrial revolution' currently taking place in China. A 'revolution' produced by massive internal restructuring, with a huge surplus population driving down real wages to such an extent that China itself is experiencing deflation. This deflation - due to the sheer magnitude of China's population - is then being systematically exported to the rest of the world. Secondly we are living globally through what could be called the 'third technological revolution' of the modern epoch (the invention of agriculture 10,000 years ago did, of course, constitute a technological revolution, and since the current 'revolution' is informational it is not necessarily an industrial one) this is driving down prices globally in the technology sectors and the strategic nature of such sectors (GPT's and all that) means that falling prices here are transmitted across the OECD economies generally. Thirdly, all the OECD country populations are ageing. The proportion of the working population in the 50-65 age group is growing steadily, and this is producing a subtle shift in the relationship between saving and current consumption along with a growing sense of price importance (the Coale/Hoover hypothesis) producing a bottom line which tends towards a deflationary environment.

Has Cecchetti made his case. I leave the reader to decide.

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