Uncertainty Over the Correct Policy Response to the Increasing Risk of Deflation

After the Fed had enormously expanded its balance sheet in response to the financial crisis, there was growing worry about the eventual potential inflationary impact of this. Currently, in what one might characterize as a paradigm shift, there is a growing chorus expressing worry about potential deflation. While there are different evaluations as to the probability of this occurring, it is no longer considered as a near impossibility. There is, however, no consensus as to what should be done to ward it off.

This shift in thinking is significant. A mistake often made in thinking about the economy is to assume that whatever has been occurring will continue indefinitely. When inflation was in double digits, many assumed this would continue. When tech stocks had their amazing rise, many assumed this would continue as the information age took hold. And, of course, it was near impossible for housing prices ever to decline -- they're not making any more land and people have to live somewhere. Projecting current conditions into the future is almost always wrong and demonstrates both a failure of imagination and an ignorance of history.

In the previous post, I mentioned that the M1 money multiplier was less than one, implying that monetary policy might not currently be the most effective tool in getting the economy going again. An interesting analysis presenting the reasons the banking system is holding excess reserves (and hence a low money multiplier) was published by the Federal Reserve Bank of New York in December 2009 ("Why are Banks Holding So Many Excess Reserves?" by Todd Keister and James J. McAndrews). At the end of the article, the authors discuss whether the excess reserves might be inflationary. They argue no, since the Fed can raise the interest rate it pays on reserves. (The Fed was granted the authority to pay interest on reserves in the TARP legislation.) By doing this, "the central bank can increase market rates and slow the growth of of bank lending and economic activity without changing the quantity of reserves." Since this was written before the paradigm shift, there is no discussion of how to deal with the opposite problem -- deflation.  Given that market rates cannot be pushed below zero, would increasing bank reserves spur lending, or would that be the equivalent of "pushing on a string"?

Some economists recommend lowering the interest rate on reserves to zero or even charging banks for excess reserves. Those opposed to this argue that it would have bad implications for the market for short-term money market instruments and for money market mutual funds. It is hard to know, since no one in the financial markets has seen rates this low.

The article does state that excess reserves do not imply that banks are not lending. If banks receive loans from the Fed to make loans rather than borrowing from banks holding excess reserves, then excess reserves go up but Fed's loan has facilitated increased lending. But it seems that direct Fed lending to banks would be a difficult policy to implement on a scale sufficient to jump start the economy.

Amazingly, some economists, recognizing that the Fed may have difficulty jump starting the economy by increasing the monetary base (which can be done by buying securities or direct loans), argue that the Fed should announce a target rate for inflation, perhaps 2%. It is hard to see how that would work. It could have a transitory announcement effect in credit markets, but talk not backed up by action will inevitably fail. The Fed saying it has a target does not mean it will be achieved any time soon nor will it prevent deflation from occurring.

Of course, others, recognizing that monetary policy has its limits, argue that the federal government should supply more stimulus. Those opposed to this state that the fiscal stimulus already supplied has not kept the unemployment rate from increasing; the counterargument is that, if not for the original stimulus, the economy would be in more dire straits and that we now know it should have been greater. A better argument against additional stimulus, though not one I find convincing, is that more stimulus would not work since it would increase the deficit and hence the stock of government debt. People would therefore not respond to the stimulus because of fear of higher taxes in the future because of this greater debt burden.

While there certainly is a risk of deflation, it is impossible to know how high that risk is.  Economists differ on what the policy response to the increasing perceived risk of deflation.  It is, though, generally conceded that once a country has entered into deflation, it is extraordinarily difficult to get out of it. One of the problems is that holding cash rather than investing it provides the equivalent of interest in real terms without risk.

While the degree of risk of deflation is unknown, there is reason to be concerned about the ability of policymakers to take measures to ward it off. The Fed appears to be unsure about what to do and what the consequences of using its monetary tools would be. Getting significant additional fiscal stimulus now is a near impossibility politically; the economic conditions that make it politically possible may necessitate an enormous amount of stimulus.

Finally, there are economists of a classical bent who seem to think, given enough time, the economy will self correct. Those with a Keynesian bent might dispute that, but, even if the classical economists are theoretically right, they ignore the political consequences of deflation and high unemployment. General economic distress could unleash highly unattractive social forces and political movements, including, perhaps, an assignment of blame to particular societal groups. The demands on the government to do something would be deafening. The hope we can have is that, if this happens, we will have enlightened and skilled political leadership that can navigate the social tumult.

The other hope we can have, of course, is that the fear of deflation is overblown. But it would be irresponsible for policymakers to ignore the risk.