eflation: low * Deflation is front runner for the Word of the Year 2003. \ * Atemporary decline in some prices does not constitute deflation. Deflation can be defined as alonger lasting decline in the general price level which reduces demand as agents hold off their purchases since they expect to gat the goods orservices cheaper later. * Deflation can result from a combination of the following factors: low current inflation, a large output gap, a slump in asset prices, external headwinds and problems in the monetary transmission mechanism (financial system). @ LJSLIMYIOU 12 LLIGKA YOR DUCA Se |p BITCH te UIC O GS} Su LOCA WK ELE —_ a « As deflation is ultimately a monetary phenomenon, monetary policy has — together with fiscal policy - the tools to fight it, butonly if both act credible and insize. As nominal interest rates cannot fall below zero, monetary policy makers would have to buy government bonds or private-sector assets cirectlyin order to pump liquidity into the systemNegative inflation rates are not a sufficient condition for deflation. Deflation in the broadest sense can be defined as: a decline in the general price level lasting for a longer period (i.e. more than two quarters) which reduces demand as agents hold off their purchases since they expect to get the goods or services cheaper later. Itis important not to misinterpret sluggish activity stemming frorn low potential GDP growth as a harbinger of deflation, because it does not necessarily increase the economy's outputgap. Under the above definition, negative inflation rates due to a terms-of-trade shock (lower commodity prices and/or an appreciating currency) would not by themselves constitute deflation. On the contrary, they could improve underlying economic conditions by increasing real purchasing power, as for example in Germany in 1986/87 The way inflation is measured rnay actually overstate the correct inflation rate by around ¥2 percentage point, asit fails to correctly take into account quality changes and substitution efiects. Therefore we might aven have a falling price level while official statistics still show srnall positive inflation rates, i.6. price stability.Falling prices due to positive supply-side shocks (for example an increase in productivity or deregulation as we have witnessed in China over the past years) are less likely to trigger deflation, because these shocks lead to falling prices and higher output. They should not squeeze profit margins and may even be positive for corporate balance sheets as they can be accompanied by rising equity prices. By contrast, negative demanctside shocks aré much more dangerous and more likely to kick off the adverse dynamics of a deflation spiral as falling prices are accompanied by declining demand and output The many dangers of deflation As deflation gets embedded in the economy it leads to a redistribution of wealth from debtors to creditors’, with the intriguing effect that both groups reduce their economic activity. Entrepreneurs and the corporate deflation, with prices falling and profit margins shrinking, the corporate sectorretrenches by cutting back irwestment and employment. This adds to the downward pressure on prices. At the same time the banking sector which ceteris paribus should be better off due to the higher real value of its loan book, will suffer higher write-offs as an increasing number of companies are no longer able to service the higher real value of their loans. As the nominal value of collateral falls, the banking sector will reduce its outstanding credit, leading to shrinking monetary aggregates. This lowers the effectiveness of traditional monetary policy measures such as rate cuts. Aliquidity trap may establish itself if banks are reluctant to lend and the private sector has no propensity to borrow, no matterOnly losers — but to different degrees As the real value of outstanding debt rises all economic activity which is financed by credit and involves big-ticket iterns witha long depreciable life will be hit hard. The corporate sector will suffer more than households as the real value of nominal fixed wages increases, while the prices of goods and services adjust more quickly. Moreover, the household sector, Why is deflation so challenging for policy makers? Deflation usually the result of policy mistakes Great Depression in the late 1920s and early 1930s prices and output collapsed within a few years, mainly due to pro-cyclical monetary tightening and technical flaws in the interwar gold standard and its Maintenance until 1933. Current deflation in Japan is also the result of policy mistakes and the government's at best lukewarm cornmitrnent to end it, as a society which is a net creditor benefits at least initially fromm low and falling inflation.deflation does more macrogconomic damage than the same amount of inflation. Even if the price trend Is correctly anticipated, in the case of deflation one gets rising real rates once the zero bound is reached, whereas anticipated inflation does not result in abnormally low real rates. Constraint from zero bound on nominal interest rates Once interest rates are approaching very low levels additional rate cuts become ineffective as shartterm government bonds and cash have become virtually interchangeable. i.e. rate cuts will have little effect on the yield curve. Excess capacity depresses pricing power Spare capacity in the economy produces downward pressure on prices, The broadest measure of excess capacity is the output gap, i.e. by how much actual GDP falls short of potential. By definition, it should be zero on average over a typical business cycle. However, as potential GDP is unobservable, the “correct” measure of the output dap is a hotlydebated At the moment the output gap is larger than 2% of GDP in all G3 economies, which switches the relevant warning lights on in our scoreboard. Also, capacity utilisation in manufacturing is more thanone standard deviation below its long-term average in the US and Japan, turing another warning light on in these two countries.Asset prices have a significant impact on the real economy. Lower equity and real estate prices depress household wealth, banks’ collateral values, and financing possibilities for companies. This tends to push up household savings rates by depressing the propensity to consume, companies’ investment and hiring plans, anc banks’ credit extension All else equal, this will lead to a widening output gap and downward oressure on prices of aoods and services High levels of household and corporate debt may also make these debtors more vulnerable and raise the danger of deflation. However, it is far from clear what an “appropriate” debt ratio is (non-stationary series). In EEE strona currency imports disinflation | Currency movements redistribute price and growth developments across countries and continents. If an economy with low inflation and a wide output gap is also hit by a strengthening currency, domestic pricing power will suffer even more and potential competitiveness gains will be eroded, The outputgap will widen further, adding to disinflationary — Today, the larae swing of the USD/EUR exchange rate is redistributing disinfiation frorn the US to the euro area. The 13% yoy appreciation of the real effective exchange rate of the euro in G1 leads toa score of "1" in this category for the euro area. The German competitive position is deteriorating less quickly because the nominal exchange rate to the rest of the euro area is fixed. Germary’s 5% real appreciation is not enough to switch a warning light onrates the long-term view — 16 2 se yowL 4 Germany 5 1 12 4 industrial countries’ CPI 10 3 8 2 6 1 4 Q 2 Japan fax fresh food) A 0 58 63 68 73 78 83 BB 93 9B 03 ? B22 94 See oe 0D OF Sb niger sbars) 1 households’ financial jon {% of disposable income) o Savings rate (night) WwW Net financial fissets (ett, inverted) f 13German households’ financial Deflation Scoreboard asset allocation (end-2001) og Insure a7 ‘ance eoreies a6 it Shares as banks, Other a4 hong equity as term flustual funds a2 with Com. a1 banks, pany short pen o torm sions, Japan (hap = = = = = + = = + = = a BO 2 84 SS Se SO Se Sa oS Se oO OS