|America's Date with Deflation?
Two years ago, at the peak of the late-1990s boom, the American economy was slightly overheated. As the unemployment rate fell to four percent and below, inflation began to creep upward, rising by between a quarter and half a percentage point each year. By late 2000 it was very clear that America's GDP was one to two percentage points above potential output--above that level at which aggregate demand balanced aggregate supply, at least in the sense that there was neither upward nor downward pressure on inflation.
Today things are very different. Today, in the summer of 2002, America's level of real GDP is running some two percentage points higher than it was in the summer of 2000. However, underneath is the extremely strong underlying productivity growth trend driven by the very real technological revolutions in data processing and data communications. These technological revolutions have boosted potential output by perhaps seven percent over the past two years. Thus today America's real GDP is not one to two percent above but three to four percent below potential output.
How do we know this? Simply look at the unemployment rate: today America is producing two percent more than it did two years ago, and is doing so with an unemployment rate not of four percent but of six percent. Moreover, the unemployment rate is more likely to rise than to fall in the next year and a half. The consensus forecast is that this year American economic growth will be positive, but will be significantly less than the rate of growth of potential output. Next year, in 2003, the consensus forecast is for American economic growth to be about 3.5% next year--equal to the rate of growth of potential output, but not enough to even begin to close the output gap.
With production substantially below potential output, there is downward pressure on American inflation. We have already seen American inflation drop nearly in half over the past two years. We do not expect this downward pressure to lessen for at least the next year and a half. If you do the math, you conclude that by the summer of 2004 the U.S. will have an inflation rate--at least as measured by the GDP deflator--that is less than zero. The U.S. will, if these forecasts come true, have joined Japan in deflation.
What does this mean? The first implication of deflation is that the central bank's ability to carry out a stimulative and expansionary monetary policy is greatly restricted. When inflation is four percent per year, the central bank can provide businesses with powerful incentives to take their spare cash and use it to build factories and buy equipment: if the central bank pushes short-term interest rates near zero, businesses are faced with the choice between investing in their business or watching the real value of their cash on hand shrink by four percent per year. When there is deflation, the central bank cannot make businesses such offers that they are unlikely to refuse: at a deflation rate of one percent per year, the real value of businesses' cash on hand grows by one percent per year even if the short-term nominal interest rate is as low as it can go.
The consensus forecast for the American economy over the next two years is not a pleasing one. Few (if any) believe that an unemployment rate of 6 percent is necessary to avoid upward pressure on inflation. Almost all are looking forward to a period with a substantial output gap: two years of sub-potential output with unemployment at its current level robs American households of some $800 billion in real production of goods and services.
More important, deflation--even slow deflation, but much more fast deflation--rapidly exposes weaknesses in businesses' and banks' capital structures. If there is the potential for a chain of bankruptcies that will disrupt the flow of funds through financial markets, cripple investment spending, and bring on a deep recession, deflation is the best way to turn that potential into an unpleasant reality.
Most important, however, is that two more years of downward pressure on the rate of inflation will rob the Federal Reserve--America's central bank--of its power to stimulate the economy. Today's GDP-deflator inflation rate is about one percent per year, meaning that today's federal funds rate target of 1.75 percent per year corresponds to a short-term real interest rate of 0.75 percent per year. If the U.S. price level in two years is not rising but falling at one percent per year, then it will be impossible for the Federal Reserve then to pursue a policy as stimulative as the Federal Reserve is pursuing now.
It is in this context that the Federal Reserve's failure to cut interest rates so far this spring and summer is very puzzling. If 1.75 percent was the appropriate interest rate last winter, when stock indices were 20 percent higher than they are today, it is hard to see how 1.75 percent can be the appropriate interest rate today. If 1.75 percent was the appropriate interest rate last winter, before the shock of revelations about corporate accounting began to drive a larger wedge of uncertain size between the terms on which the government can borrow and the terms on which private businesses can raise capital, than 1.75 percent is unlikely to be the appropriate interest rate today. And if the Federal Reserve wishes--as it surely does--to preserve its power to offset and neutralize any future contractionary shocks to the economy that may appear, then the current inflation rate is already dangerously low and already leaves it with remarkably little room for action.
Now none of this means that the American economy is about to run aground. But anyone who has ever sailed a sailboat knows that it is not enough to be far enough away from shore that there is still water under your keel. You have to be able to plot a course that will keep water under your keel. And you have to plot a course that will keep water under your keel even if Mother Nature decides not to cooperate: even if the wind shifts so that you can no longer hold your preferred course, or even if the wind freshens so that your boat is blown sideways more rapidly. The first rule of prudence--in sailboats and in monetary policy-setting committees--is to keep away from situations in which one or even two adverse shocks will cause severe difficulties.
Thus it is disturbing that the consensus forecast seems to paint a picture of the U.S. economy two years hence in which production remains substantially below potential output, and in which slight deflation has taken hold and robbed the Federal Reserve of its power to offset adverse shocks. The current course seems to carry the U.S. economy too close to a lee shore with a potentially freshening wind. It is a course that prudent sailors should not be happy to hold but should be scrambling to change.
J. Bradford DeLong (2002), "America's Date with Deflation," Financial Times (London: August 21, 2002).