Why is Deflation a Central Bank's Worst Nightmare?

Once deflation sets in, it can take decades for an economy to break out of its grip—Japan is still trying to climb out of a deflationary spiral dubbed the Lost Decades that began in 1990. But what can central banks do to fight the pernicious and devastating effects of deflation? In recent years, central banks around the world have used extreme measures and innovative tools to combat deflation in their economies. Below, we discuss how central banks fight deflation.

Deflation is defined as a sustained and broad decline in price levels in an economy over a period. Deflation is the opposite of inflation and is also different from disinflation, which represents a period when the inflation rate is positive but falling.

Brief periods of lower prices, as in a disinflationary environment, are not bad for the economy. Paying less for goods and services leaves consumers with more money left over for discretionary expenditures, which should boost the economy. In a period of declining inflation, the central bank is not likely to be "hawkish" (in other words, poised to aggressively raise interest rates) on monetary policy, which would also stimulate the economy.

But deflation is different. The biggest problem created by deflation is that it leads consumers to defer consumption of big-ticket items like appliances, cars and houses. After all, the possibility that prices may go up is a huge motivator for buying big-ticket items (which is why sales and other temporary discounts are so effective).

In the United States, consumer spending accounts for 70% of the economy, and economists consider it one of the most reliable engines of the global economy. Imagine the negative impact if consumers defer spending because they think goods may be cheaper next year.

Once consumer spending begins to decelerate, it has a ripple effect on the corporate sector, which begins to defer or slash capital expenditures—spending on property, building, equipment, new projects and investments. Corporations may also begin downsizing to maintain profitability. This creates a vicious circle, with corporate layoffs imperiling consumer spending, which, in turn, leads to more layoffs and rising unemployment. Such contraction in consumer and corporate spending can trigger a recession and, in the worst-case scenario, a full-blown depression.

Another hugely negative effect of deflation is its impact on the debt burden. While inflation chips away at the real (i.e., inflation-adjusted) value of debt, deflation adds to the real debt burden. An increase in the debt burden during a recession increases defaults and bankruptcies by indebted households and companies.

Over the past quarter-century, concerns about deflation have spiked after big financial crises and/or the bursting of asset bubbles such as the Asian crisis of 1997, the "tech wreck" of 2000 to 2002 and the Great Recession of 2008 to 2009. These concerns have assumed center stage in recent years because of Japan's experience after its asset bubble burst in the early 1990s.

To counter the Japanese yen's 50% rise in the 1980s and the resultant recession in 1986, Japan embarked on a program of monetary and fiscal stimulus. This caused a massive asset bubble as Japanese stocks and urban land prices tripled in the second half of the 1980s. The bubble burst in 1990 as the Nikkei index lost a third of its value within a year commencing a slide that lasted until October 2008 and brought the Nikkei down 80% from its December 1989 peak. As deflation became entrenched, the Japanese economy—which had been one of the fastest-growing in the world from the 1960s to the 1980s—slowed dramatically. Real GDP growth averaged only 1.1% annually from 1990. In 2013, Japan's nominal GDP was approximately 6% below its mid-1990s level. (For more on the Japanese economy, see: From Mrs. Watanabe to Abenomics - the Yen's wild ride).

The Great Recession of 2008 to 2009 sparked fears of a similar period of prolonged deflation in the United States and elsewhere because of the catastrophic collapse in prices of a wide range of assets—stocks, mortgage-backed securities, real estate and commodities. The global financial system was also thrown into turmoil by the insolvency of a number of major banks and financial institutions in the United States and Europe exemplified by the bankruptcy of Lehman Brothers in September 2008 (To learn more, read: Case Study – The Collapse of Lehman Brothers). There were widespread concerns that scores of banks and financial institutions would fail in a domino effect leading to a collapse of the financial system, a shattering of consumer confidence and outright deflation.

Chairman Ben Bernanke of the Federal Reserve had already acquired the moniker of "Helicopter Ben." In a 2002 speech, he had referenced the economist Milton Friedman's famous line that deflation could be countered by dropping money from a helicopter. Although Bernanke did not have to resort to the helicopter drop, the Federal Reserve used some of the same methods outlined in his 2002 speech from 2008 onwards to combat the worst recession since the 1930s.

In December 2008, the Federal Open Market Committee (FOMC, the Federal Reserve's monetary policy body) cut the target federal funds rate essentially to zero. The fed funds rate is the Federal Reserve's conventional instrument of monetary policy, but with that rate now at the "zero lower bound" – so-called because nominal interest rates cannot go below zero – the Federal Reserve had to resort to unconventional monetary policies to ease credit conditions and stimulate the economy.

The Federal Reserve turned to two main types of unconventional monetary policy tools: (1) forward policy guidance and (2) large-scale asset purchases (better known as quantitative easing (QE)).

The Federal Reserve introduced explicit forward policy guidance in the August 2011 FOMC statement to influence longer-term interest rates and financial market conditions. The Fed stated that it expected economic conditions to warrant exceptionally low levels for the federal funds rate at least through mid-2013. This guidance led to a drop in Treasury yields as investors grew comfortable that the Fed would delay raising rates for the next two years. The Fed subsequently extended its forward guidance twice in 2012 as a tepid recovery caused it to push the horizon for keeping rates low.

But it is quantitative easing that has made headlines and become synonymous with the Fed's easy-money policies. QE essentially involves the creation of new money by a central bank to buy securities from the nation's banks and pump liquidity into the economy and drive down long-term interest rates. This ripples through to other interest rates across the economy, and the broad decline in interest rates stimulates demand for loans from consumers and businesses. Banks can meet this higher demand for loans because of the funds they have received from the central bank in exchange for their security holdings.

The timeline of the Fed's QE program was as follows:

• Between December 2008 and August 2010, the Federal Reserve purchased $1.75 trillion in bonds, comprising $1.25 trillion in mortgage-backed securities issued by government agencies like Fannie Mae and Freddie Mac, $200 billion in agency debt and $300 billion in longer-term Treasuries. This initiative subsequently became known as QE1.
• In November 2010, the Fed announced QE2, wherein it would buy another $600 billion of longer-term Treasuries at a pace of $75 billion per month.
• In September 2012, the Fed launched QE3, initially buying mortgage-backed securities at a pace of $40 billion per month. The Fed expanded the program in January 2013 by buying $45 billion of longer-term Treasuries per month for a total monthly purchase commitment of $85 billion.
• In December 2013, the Fed announced that it would taper off the pace of asset purchases in measured steps and concluded the purchases in October 2014.

Other central banks have also resorted to unconventional monetary policies to stimulate their economies and stave off deflation.

In December 2012, Japanese Prime Minister Shinzo Abe launched an ambitious policy framework to end deflation and revitalize the economy. Called “Abenomics," the program has three main elements—(1) monetary easing, (2) flexible fiscal policy and (3) structural reforms. In April 2013, the Bank of Japan announced a record QE program. The central bank announced that it would buy Japanese government bonds and double the monetary base to 270 trillion yen by the end of 2014 with the objective of ending deflation and achieving inflation of 2% by 2015. The policy objective of slashing the fiscal deficit in half by 2015 from its 2010 level of 6.6% of GDP and achieving a surplus by 2020 commenced with an increase in Japan's sales tax from 5% to 8% in April 2014. The structural reforms element required bold measures to offset the effects of an aging population, such as allowing foreign labor and employing women and older workers. 

In January 2015, the European Central Bank (ECB) embarked on its own version of QE by pledging to buy at least 1.1 trillion euros of bonds at a monthly pace of 60 billion euros through to September 2016. The ECB launched its QE program six years after the Federal Reserve in a bid to support the fragile recovery in Europe and ward off deflation. Its unprecedented move to cut the benchmark lending rate below 0% in late-2014 had met with limited success.

While the ECB was the first major central bank to experiment with negative interest rates, a number of central banks in Europe, including those of Sweden, Denmark and Switzerland, have pushed their benchmark interest rates below the zero bound. What will be the consequences of such unconventional measures?

The torrent of cash in the global financial system as a result of QE programs and other unconventional measures have paid off for the stock market. Global market capitalization exceeded $70 trillion for the first time in April 2015 representing an increase of 175% from the trough level of $25.5 trillion in March 2009. The S&P 500 has tripled over this period while many equity indices in Europe and Asia are currently at all-time highs.

But the impact on the real economy is less clear. According to Reuters, reporting on estimates from the Congressional Budget Office, U.S. economic growth will slow in 2019 to less than the 3% quoted by the Trump administration as the effect of the fiscal stimulus fades. Meanwhile, the concerted moves to fend deflation globally have had some strange consequences:  

• Central bank balance sheets are bloating: Large-scale asset purchases by the Federal Reserve, Bank of Japan and the ECB are swelling up their balance sheets to record levels. The Fed's balance sheet has grown from less than $870 billion in August 2007 to over $4 trillion in October 2018. Shrinking these central bank balance sheets may have negative consequences down the road.
• QE could lead to a covert currency war: QE programs have led to major currencies plunging across the board against the U.S. dollar. With most nations having exhausted almost all their options to stimulate growth, currency depreciation may be the only tool remaining to boost economic growth, which could lead to a covert currency war. (To learn more, read: "What is a currency war and how does it work?").
• European bond yields have turned negative: More than a quarter of government debt issued by European governments currently has negative yields. This may be a result of the ECB's bond-buying program, but it could also be signaling a sharp economic slowdown in future.

The Bottom Line

The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war. An unspoken fear is that central banks may have expended most, if not of all of their ammunition, in beating back deflation. If this is the case in the years ahead, deflation could be exceedingly difficult vanquish.