Transcript | 7. lecture: Inflation versus deflation (Vladimír Vaňo) - University for modern Slovakia

Is widespread consumer drop in price as good as it seems?

• Price decrease is for every consumer more effective alternative than its increase.  What about all the prices in the economy? How are they shown on a sample of consumer basket in consumer price index (CPI)? Is a better scenario inflation (widespread increase of consumer prices) or deflation (widespread more stable decrease of consumer prices)? The answer is more difficult than one might assume at first sight.
• Not only academic theories but practice of the third strongest economy of the world as well, has shown that deflation – long-lasting widespread decrease of consumer prices – is usually connected to the period of economic stagnation.
• Furthermore, available instruments of monetary and fiscal policy are helpless against deflation. In combination with economic stagnation, deflation can be naturalized in the economy the way which can be very difficult to stop. It is illustrated in the video to this lecture thought the development of some indicators from Japan.

Japan lecture: Avoid onset of deflation no matter cost

• The aim of monetary policy therefore is not only stable and low inflation, i. e. to avoid an inadequate increase of consumer prices. The monetary policies of central banks try to avoid appearance of deflation, i. e. long-lasting widespread decrease of consumer prices.
• Also for the experience of Japan, which can today be called as notorious “lost decade”, the central banks try, except reaching stable and low inflation, using available instruments to avoid deflation which threatens mostly during the time of recession.
• As an example of Fed from the recent years has shown, the threat of deflation and its consequences is in FED considered to be so serious that FED was disposed to accede to special measures to liberalize monetary policy for the purpose of avoiding the same situation of Japanese scenario.
• American central bank FED was disposed to act against the threat of deflation literally by all available instruments. 

Inflationary spiral mechanism

• Mechanism of self-fulfilling mechanism of inflationary spiral is known to everybody:
  • Given the strong growth of consumer demand in the times of expansion the pace of growth of consumer prices accelerates.
  • Faster growth of inflation leads to expectation adjustment of households and companies.
  • Higher inflationary expectations of households lead to higher requirements for wage rise as a lump sum (what is dangerous mostly when wage rise as a lump sum comes before the rise of labour productivity).
  • Higher inflationary expectations of companies lead to the state when they expect higher “inflationary” product price rise in their business plans for the future. Furthermore, acceptance of higher inflationary expectations on the side of business plans make companies more open to area requirements for area wage rise (i.e. expenses).
  • Since price rise in shops matches the expectations of consumers to whom the employers compensate this rise, the high inflation from the previous period is with high possibility to be repeated in the next period. In case of continuation of strong expansion even inflation can have the tendency to rise further.
  • After deceleration of economic growth, the economy can experience weaken demand from the persistence of high inflation which causes unbalance (inappropriate high prices and related inadequate allocation of sources) and correction of whose can be in the next period of economic cycle more radical.
  • High inflation, on one side, depreciates purchasing power of wages and savings.
  • High inflation also makes business planning of the companies more difficult, it exposes businessmen to the environment of fast inflationary increase of their expenses.
  • Inadequate fast price rise can lead to the wrong signals and inadequate allocation of the company´s sources.
  • Consumers and savers therefore give preference to lower inflation, slower depreciation of wages and savings.
  • Private businesses prefer lower but primarily stable and predictable inflation.
  • For more stable development of economy and for avoiding of often appearing macroeconomic unbalances (e.g.: area wage rise which if exceeds productivity makes competitiveness of labour force weaker), for the economy is the most optimal a stable moderate and predictable development of inflation.
  • Besides this and according the economic theories, the best contribution of monetary policy to the long-lasting economic growth is regarded an effort to reach stable development of inflation.

Monetary policy instruments to beat the inflation

• When the strong rise causes acceleration of consumer prices increase in the name of fulfilling its primary aim (stable inflation), a central bank can accede to basic standard measures:
  • to increase basic interest rates:
    • which is subsequently visible in movement of interests, makes credits more costly, and leads to weakening of demand for investment loans, slowing investment growth and growth in jobs therefore to weakening of consumer demand pressures to inflation.
    • Besides this, higher basic rates of a central bank motivate the financial sector to hold the bigger amount of most liquid assets on more interest-bearing risk-free accounts in a central bank instead of lending them with some credit risk.
    • Credit growth slows from the side of demand as well as from the side of offer.
•  To increase of minimum reserves rate:
  • When increasing minimum reserves rate, central bank as a regulator, orders directly to the financial sector to hold bigger amount of most liquid assets on their accounts which restricts the process of credit expansion.
  • By increase of basic interest rate or by increase of minimum reserves rate, a central bank inhibits the process of credit multiplication which from most liquid assets makes wider money supply (M2 resp. M3).
  • Making the credits more costly, limitation of accessibility of most liquid assets and results of these - slowing growth of money supply leads to pressure inhabitation to growth of consumer prices.
  • Common available measures of monetary policy are able to deal with inhibiting unhealthy fast economy growth as well as with inhibiting too high inflation which can accompany it. It can be at the cost of (temporary) double-digit interests.

Deflationary spiral mechanism

• Long-lasting consumer prices drop can through inflationary (in this case deflationary) public expectations lead to similar self-fulfilling mechanism of deflationary spiral:
  • General consumer prices drop leads to postpone purchase by consumers: they can see that the same product cheapens in time and purchasing power of their money increases with waiting for the cheaper product/goods.
  • Sellers and producers in the environment of consumer prices drop face weaker demand but also if they are able to sell “the same amount of pieces of goods”, their revenues are lower because of lower prices.
  • Lower prices with the same amount of sold goods make pressure to fall of sellers/producers´ profitability.
  • Pressure to fall of profitability leads to the need to find optimization of expenses including employment.
  • The environment of weaken demand (regardless of the same amount of sold goods, lower revenues and lower profit) discourages the companies from investment plans, modernization, or expansion of production (which is connected with employment).
  • Companies´ interest to have new loans is lower regardless of the development of its loan interests.
  • Lower employment and rise of unemployment arouse in households higher doubts and uncertainty in labour market.
  • In the environment of higher uncertainty in labour market, the households change their behavior: they increase proportion of saved money from their income counter to consumption (increase of propensity to save against decrease of propensity to consume).
  • In the environment of consumer prices drop or increasing purchasing power of savings, the frugality caused by uncertainty in labour market, the households´ interest to have consumer loans. This is because of their fear of job loss as well as the possibility they can buy the same product cheaper later on.
  • The change of consumer behavior, higher propensity to save against lower propensity to consume leads to further weakening of domestic consumer demand. The circle is now complete.
  • Deflation is not a short-term interannual drop of consumer prices, which the euro-area experienced in summer 2009, but long-lasting period of interannual drop of general price level.
  • Deflation is not a price drop in any of the categories of consumer basket (if at the same time, the total inflation is positive).
  • Deflation is a long-lasting general drop of consumer prices measured by CPI index.

Monetary policy instruments to beat the deflation

• In the time of weaken economic growth and slower inflation, common reaction of a central bank is lowering interest rates, later supplying most liquid assets through quantitative instruments of monetary policy.
• The aim of liberalization of monetary policy is not only to support withering economic growth but also avoiding serious weakening of demand to cause deflation.
• In case of long-lasting deflation, the common instrument of monetary policy are seen helpless:
  • Not even the record-breaking low interest rates can obvert the decrease of lower propensity to consume by deflationary expectations of public. The environment of increasing purchasing power of money and the uncertainty in labour market discourages the households´ interest in loans.
  • Not even the record-breaking low interest rates can motivate companies to apply for new loans for new investment projects: for the reason of demand drop, they face rather unused existing capacities, the pressure caused by revenues and profit drop forces them to try to find the ways how to lower expenses, not to make them higher (e.g. by increasing proportion of fixed costs per production unit if they decide for investment into expansion or modernization of capacities).
  • The environment of rising unemployment, i. e. higher credit risk of households, and revenues and profit drop, i. e. higher credit risk of companies, leads banking sector to higher caution when providing new credits/loans. Not low interests and sufficiency of most liquid assets in deflationary environment is a warranty for revitalization of credit activity.
  • As the monetary policy, on the side of demand as well as on the side of offer, cannot influence the motivation of private sector (to optimize expenses, lower the propensity to consume), the record-breaking interests or sufficiency of most liquid assets in banking system are not warranty to be efficient in breaking the deflationary spiral.
  • Because of the inefficiency of liberalized monetary policy when beating the inflation, the situation of monetary policy in Japan is known as the liquidity trap: the extraordinary liberalized monetary policy and availability of most liquid assets in the environment of long-lasting deflation do not guarantee revitalization of interest in investment, stronger growth of economic activity and employment.
  • The danger, which comes with long-term interannual consumer prices drop for the formation of inflationary expectations of public, leads to the situation when central banks must be careful not only when there is a short-term interannual price drop but also when inflation rapidly slower to zero levels.
  • Therefore central banks when aiming the inflation do not attempt for reaching the lowest possible inflation but for keeping the inflation on low but stable levels near to inflationary target.
  • In terms of ECB, the inflationary target is defined as “the inflation lower than, but close to level of 2%”.
  • Because of the fear of deflation, many central banks when aiming the inflation, except their inflationary target, set the range for maximum and minimum allowable inflation. At the same time, when aiming the inflation, the limit of minimum range is not zero (for example Bank of England or National Bank of Poland).

Japanese experience with combination of deflation and stagnation

• After a serious recession in mid 90s, the consumer prices rise lowered to the negative level (see the graph in video). Inflation in Japan remains in red numbers or near zero up to these days.
• The environment of deflation accompanies often recessions or periods of a slight economic growth, stagnation (see the graph in video).
• As a result of long-lasting combination of deflation and stagnation is rise of unemployment rate to almost two-digit level compared to the period before the beginning of deflation (see the graph in video).
• The Bank of Japan reacted after the beginning of deflation (see the graph in video) to the liberalization of monetary policy by regulating the interests to almost zero interests.
• Long-lasting liberalization of monetary policy of the Bank of Japan (by lowering interests and by quantitative instruments) was not able to revitalize the interest of private sector in loans in the environment of deflation. For a long time, Japan faced faster growth of most liquid assets than was the growth of total money supply (see the graph in video).
• Nor the record-breaking interests, either quantitative liberalization of monetary policy were able to strengthen domestic demand in the environment of deflation (see the graph in video).
• The combination of unemployment in the environment of deflation means that neither lowered propensity to consume could enrich Japanese households as a whole: however, the rate of their savings is incomparably higher than the one in the USA, compared to the total disposable income during the period of stagnation it decreased - “if one household saves, it is good for that household, if all the household save, it is good for nobody” (see the graph in video).
• As a result of ineffective attempts for revitalization of growth by monetary stimuli, also as a result of stagnation of weakened monetary incomes, the deficit economy of Japanese government led to rapid increase of public debt to the level of 200% of GDP (see the graph in video).

Experience with monetary stimuli as a solution for combination of deflation and stagnation

• The case of Japan illustrates that inefficient are not only instruments of monetary policy but also instruments of fiscal policy when beating the deflationary spiral.
• Nor temporary stimuli in the form of increased deficit economy of state budget cannot fight effectively against negative motivations of private sector aroused by deflation (inhibiting of new investments, optimizing of unemployment, higher propensity to save in the environment of uncertainty in labour market).
• Besides this, in the environment of deflation and connected stagnation or decrease of economic efficiency, state budgetary incomes are under negative pressure as well.
• The long-lasting stagnation and repeating inefficient attempts to revitalize economic growth by budgetary stimuli ended in Japan in fast growth of public debt to the level approximately of twice the amount of GDP.

The best cure is early prevention: to avoid deflation at any cost

• The ineffectivity of monetary policy in the time of deflation leads the theorists (some of them later became central bankers, as e.g. Ben Bernanke) to the theory that the most effective instrument against deflation is to avoid it by all available instruments.  
• That is why the central banks, mostly in the cases of serious recessions, interfere by exceptional preventive liberalization of monetary policy not to experience undesirable slowing of inflation before consumer prices growth is in black numbers (whereas the economic activity slows down already).

Conclusion: Japanese experience is better not to risk

• During the recession, Fed and ECB did their best to avoid deflationary experience of Japan.
• The standard instruments of monetary policy are able to effectively inhibit unhealthy strong economic growth but also too fast inflation.
• To fight Japanese combination of deflation and long-lasting stagnation are common instruments of monetary and fiscal policy helpless.
• The experience with long-lasting combination of stagnation and deflation in Japan shows that probably the most effective and available instrument against deflation is to try to avoid it by all available means.
• The effort to avoid the deflation leads Fed and ECB during the most serious recession after war to exceptional liberalization of monetary policy not only by decreasing of basic interest rates but by quantitative instruments as well.
• The risks which are connected to deflationary spiral remind the importance of stable economic environment which (unnecessarily) does not put in danger investment and business trust of private sector (and vicariously employment and related consumer trust of households).