Other Titles in the Occasional Paper Series Deflation: Determinants, Risks, and Policy Options—Findings of an Interdepartmental Task Force, April 30, 2003

O C C A S I O N A L   P A P E R       221       Deflation: Determinants, Risks, and Policy Options Manmohan S. Kumar, Taimur Baig, Jörg Decressin, Chris Faulkner-MacDonagh, and Tarhan Feyziogùlu ©2003 International Monetary Fund June 30, 2003 Order Information for full text in hard copy  (abstract below) Foreword Acknowledgements I Overview   Conclusions II Measurement, Determinants, and Costs   Definition and Recent Experience   Determinants   Costs of Deflation III Historical Experiences of Deflation and Policy Lessons Deflation in the Nineteenth Century Deflation in the Early Twentieth Century IV Risks of Deflation Global Deflationary Pressures Overall Assessment Deflationary Pressures in the Major Economies China     V Policy Response Policy Before the Onset of Deflation Policy Once Deflation Has Set In Appendices I  Index of Deflation Vulnerability—Data Sources and Definition of Variables II Supplementary Material References Boxes 1. United States: Economic Outlook and Deflation Risks 2. Deflationary Pressures in Germany 3. Deflation in Japan 4. China: Recent Deflation Episodes 5. Inflation Targeting and Deflation Risks Text Tables 1. Incidence of Deflation and Low Inflation: Consumer Prices 2. Incidence of Deflation and Low Inflation: Producer Prices 3. Index of Deflation Risk, with Latest Data (Weighted) 4. Index of Deflation Risk, with Latest Data (Equal Weight) 5. Index of Deflation Risk, 1995 (Weighted) 6. Index of Deflation Risk, 1995 (Equal Weight) 7. Deflation Risk: Incremental Changes in Output and Unemployment Gaps Figures 1. Goods Prices 2. Inflation Rates (CPI) 3. Aggregate Demand and Supply Shocks 4. Monetary Policy in a Liquidity Trap 5. GDP Growth and Output Gap in the G-7 6. Inflation Target and Zero Bound A1. CPI and GDP Deflator in the G-7 A2. CPI and GDP Deflator in Other Advanced Economies A3. CPI and GDP Deflator in Asian Economies A4. CPI and GDP Deflator in Other Emerging Market Economies A5. Producer Prices A6. Consumer Prices and Inflation, 1801Ð2001 A7. Yield Differential Between Nominal and Index-Linked-Government Bonds A8. Commodity Prices A9. GDP Growth and Output Gap in Asian Emerging Market Economies A10. GDP Growth and Output Gap in Other Emerging Market Economies A11. Equity Prices in Industrial Countries A12. Equity Prices in Emerging Markets A13. Price-Earnings Ratios in G-7 Economies A14. Real Effective Exchange Rates A15. Private Sector Credit A16. Equity Prices Relative to Peak Values A17. Real Residential Price Indices A18. Trade Shares and Exports A19. China: Regional and Global Trade A20. China: Transmission of Deflation

I. Overview Concerns of a generalized decline in prices in both industrial and emerging market economies have increased markedly since last fall. With Japan, China, and several other Asian economies already experiencing declining prices, the worry has been that deflationary pressures could deepen, and even spread more widely. This concern comes amid massive declines in global equity markets; significant excess capacity and widening output gaps; repeated disappointments over the pace of global recovery; geopolitical uncertainties; and the impact on activity of higher oil prices. This is the second time in the past five years that widespread concerns about deflation have come to the fore—the first being during and in the aftermath of the Asian crisis. Public discussion in many countries, including the United States and Germany, has centered on risks of the onset of deflation, with increasing attention levied to such risks by policymakers. These developments are notable given that for over four decades markets and policymakers have been more concerned about inflation than deflation. In light of the above, an IMF task force investigated issues related to the causes and consequences of deflation, the conjunctural risks in individual economies and globally, and policy options. This paper presents the findings of the task force and focuses on four areas: Analytical framework (Section II), which discusses issues related to the measurement, determinants, and costs of deflation. Historical experiences (Section III), which evaluates deflation in the nineteenth century and during the Great Depression, along with the recent experience of Japan and China. Risk assessment (Section IV). A central part of the paper focuses on developing and implementing a framework for assessing deflation risks using three complementary approaches. First, it computes an index of deflation vulnerability based on a set of indicators for each of 35 of the largest industrial and emerging market economies—accounting for over 90 percent of global GDP. The index reflects developments in aggregate prices, outputs gaps, asset markets, and credit and financial markets. Second, an expectations-augmented Phillips curve provides an estimate of the size of the deflationary shock (increase in output gap and unemployment gap) that would be required for the onset of deflation, or persistent deflation. Third, a case study examines China’s role in transmitting a deflationary impulse. Policy response (Section V). This section reviews options available to policymakers both before and after the onset of deflation. Conclusions Analytical Framework and Historical Experience Both demand and supply shocks can lead to deflation. However, with demand shocks declining prices are likely to accompany falling demand for goods and services, while with supply shocks, declining prices might be accompanied by increases in output. Nonetheless, deflation is seldom benign. Regardless of its source, deflation leads to a redistribution of income from debtors to creditors. In addition, credit intermediation can be distorted as collateral loses value. Given the zero interest-rate floor, the effectiveness of conventional monetary policy is curtailed, and this is of particular concern when output is weakening. Persistent deflation risks turning into a deflationary spiral of falling prices, output, profits, and employment. Deflation can be costly and difficult to anticipate. Deflation was not uncommon in the nineteenth century, but even then its duration was often unanticipated. In the late 1920s and early 1930s, U.S. policymakers exacerbated deflation by underestimating its consequences and by failing to take aggressive action. In contrast, countries that exited the gold standard earlier—such as Sweden and Japan—recovered from deflation relatively quickly. Historically, deflation generally muted growth prospects, although it was mainly during the Great Depression that the most severe effects of deflation were felt. Risk Assessment Based on the Index of Deflation Vulnerability, the risk of an onset of deflation in a number of economies is seen to be relatively high and has drifted upward over the past several years. The risk occurs against a background of postwar low inflation rates; large output gaps; the bursting of the equity price bubble; rising banking sector stresses in some economies; and declining credit growth. Asian economies, Japan in particular—but also Hong Kong SAR and Taiwan Province of China—are at risk of worsening deflation. Deflationary expectations appear to be entrenched, and in Hong Kong SAR, policy is constrained. In China, the strong pace of activity and policy stimulus already in the pipeline are likely to contain deflation. However, strains may arise in China from the large pool of underutilized labor and excess capacity in many sectors. In the euro area, core inflation has been slow to decelerate, and, except for Germany, risk of deflation remains low in the major countries. Germany suffers from a weak macroeconomic environment, a large and increasing output gap, high unemployment, and banking-sector strains, with limited policy options. Outside the euro area, Switzerland appears to have a moderate risk but—unlike Germany—there is greater scope for policy measures. In the United States, despite the lingering effects of the bursting of the equity price bubble, risk of deflation appears relatively low. The lower risk reflects an expected narrowing in the output gap; relief provided by a recent depreciation of the U.S. dollar; the resilience in the financial sector; the availability of policy stimulus; and the explicit willingness of policymakers to take preemptory action. The task force did not find evidence to support strong concerns of generalized global deflation.1 It also did not see any compelling evidence of widespread international transmission of deflation. However, the high correlation of business cycles across countries creates a non-zero, but still low, probability of a simultaneous decline in prices. Policy Response What can be done to protect against deflation? Policies can be effective in warding off deflation, but only if preemptive, forceful, and sometimes unconventional steps are taken. Correspondingly, deflation is more likely, or more likely to be persistent, when policy is constrained, or not sufficiently forward-looking, or when policymakers are too dismissive of their ability to act. It is better to prevent deflation than to try to cure it, and monetary policy must take the lead. Since the risks of deflation are asymmetric, policy must be attuned to deflationary impulses in a low inflation environment. Further, because these impulses can also impede the monetary transmission mechanism, aggressive action is required. At the zero bound on nominal interest rates, additional unorthodox measures may be needed. Stimulatory fiscal policies can play an important complementary role; their beneficial effects could be enhanced if measures are adopted to raise the rate of return to the economy, so as to spur investment and output. Structural reforms, particularly those improving credit intermediation, could also be beneficial. 1The Severe Acute Respiratory Syndrome (SARS) epidemic could have substantial demand side effects with adverse consequences for the pace of activity and deflationary pressures in several countries. The analytical work in this report was completed before the extent of the fallout from SARS was recognized.