William White says central bankers have started to miss the monetary-policy forest for the trees. He sees little evidence macroprudential tools work in the long run and may help mis-price assets

By William White*

The major central banks’ vigilant pursuit of positive but low inflation has become a dangerous delusion. It is dangerous because the policies needed to achieve the objective could have unwanted side effects; and it is a delusion because there is currently no good reason to be pursuing the objective in the first place.

In the 1970s, when inflation in the advanced economies rose sharply, central banks rightly resisted it. The lesson central bankers took from that battle was that low inflation is a necessary condition for sustained growth. But, subtly and over time, this lesson has morphed into a belief that low inflation is also a sufficient condition for sustained growth.

That change may have been due to the benign economic conditions that accompanied the period of disinflation from the late 1980s to 2007, commonly referred to as the “Great Moderation.” For central bankers, it was comforting to believe that they had reduced inflation by controlling demand, and that their policies had many beneficial side effects for the economy. After all, this was the demand-oriented narrative they had used to justify tight money to begin with.

But then the world changed. From the late 1980s onward, low inflation was largely due to positive supply-side shocks – such as the Baby Boomer-fueled expansion of the labor force and the integration of many emerging countries into the global trading system. These forces boosted growth while lowering inflation. And monetary policy, far from restricting demand, was generally focused on preventing below-target inflation.

As we now know, that led to a period of easy monetary conditions, which, together with financial deregulation and technological developments, sowed the seeds of the 2007 financial crisis and the ensuing recession. The fundamental analytical error then – as it still is today – was a failure to distinguish between alternative sources of disinflation.

The end of the Great Moderation should have disabused policymakers of their belief that low inflation guarantees future economic stability. If anything, the opposite has been true. Having doubled down on their inflation targets, central banks have had to rely on an unprecedented array of untested policy instruments to achieve their goals.

For example, many central bankers are now recommending the use of “macroprudential” instruments to manage systemic risks in the economy – which, in turn, will allow them to keep interest rates “lower for longer.” The problem with this approach is that there is little, if any, empirical evidence to suggest that such policies will work as intended.

Central bankers sometimes rationalise their current policies not by extolling the benefits of low inflation, but by underscoring the heavy costs of even mild deflation. Yet while there is ample evidence showing that high inflation is more costly than low inflation, it is hard to find similar evidence that mild deflation is all that costly.

In fact, the widely held assumption that consumers and corporate investors will extrapolate from past price declines and hold off on making purchases as a result of deflation has essentially no empirical support behind it. Recent consumer responses to sectoral price declines in various countries, not least Japan, all suggest the very opposite.

True, as a matter of arithmetic, deflation increases the real (inflation-adjusted) burden of debt service. But if debt levels are at onerous heights as a result of easy-money monetary policies, it is not obvious that the solution to the problem is still more easy money.

Central banks’ fixation on positive but low inflation under today’s prevailing economic conditions is also increasingly dangerous. Global debt ratios have risen sharply since the financial crisis began, while traditional lenders’ margins have been squeezed, raising questions about their overall health. And as lending has continued to migrate further into the “shadows,” price discovery in financial markets has become severely compromised, to the point that many assets now seem to be overvalued.

These developments constitute a threat not just to financial stability, but also to the workings of the real economy. Moreover, one could argue that easy money itself has contributed to the unexpectedly strong disinflationary forces seen in recent years. Owing to easy financing and regulatory forbearance, aggregate supply has risen as “zombie” companies have proliferated. Meanwhile, aggregate demand has been restrained by the debt headwinds – yet another result of easy monetary conditions.

In view of these conditions, continuing to insist on monetary easing seems particularly ill advised. With so many potential dangers on the horizon, central bankers should at least consider rethinking the fundamental assumptions underlying their policies.

So, what should policymakers do? In the immediate future, governments must stop relying so much on central bank policies to restore sustainable growth. Rather than obsesses over inflation targets, policymakers should (belatedly) start asking themselves what practical measures they can take to prevent another crisis from erupting. Equally important, they need to ensure that they have done everything they can to prepare for such a scenario, in case their preventive measures prove inadequate.

Looking even further into the future, when some semblance of “normality” has been restored, central banks should focus less on hitting near-term inflation targets, and more on avoiding “boom-bust” credit cycles. Unlike slight deviations from inflation targets, or even slight deflation, the latter actually are costly.


William White, a former deputy governor of the Bank of Canada, and a former head of the Monetary and Economic Department of the Bank for International Settlements, is Chairman of the Economic and Development Review Committee at the OECD. Copyright: Project Syndicate, 2017, published here with permission.

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16 Comments

The problem is that slight deflation could easily escalate into strong deflation, then that would be dangerous.

as opposed to inflation destroying your savings and earnings? deflation gives you more for your money and could be a natural effect of a correction, after rapid money expansion.

Deflation is not dangerous! That's what 'we've' been told because it doesn't suit a minority of people who have a lot to lose. Deflation is a necessary part of any dynamic economy. It's the mirror image of Inflation. It's 'outlawing' any part of System that is dangerous....not Deflation itself...and that is what 'we' have tried to do - actively ( QE; lowering interest rates etc) and passively ( "Frighten The People into believing it's going to be The End of Time if ever Deflation takes hold"). And guess what? Most people fall for it!

Deflation IS dangerous. Consider those found mired in debt on its arrival. Debt does not deflate. As opposed to inflation, deflation is near impossible to eliminate (Japan post 1989).

Why would I buy a big ticket item when its either going to be cheaper tomorrow or at best stays the same and I have to fork out precious money to maintain it!?

I think we are only one more financial shock away from finding out just how dangerous it is.....cash becomes king.

So it is Debt that's dangerous? And who stops buying the latest iPhone today, even when they know it will be half price next year?!
Debt does Deflate, or it should do, via Productivity. If Debt earns more that is costs, it will deflate. The problem is...when it doesn't; when holding an asset that 'returns' 3% is funded by debt that costs 5%. That...is what is dangerous and what Deflation in a dynamic system should stop happening. But we have 'outlawed' that, and yes, WILL have to face the consequences...one way or another.

Deflation is only dangerous to those with too much debt. Those that save will flourish and one hopes it will finally teach our population that saving is important.

Official measured CPI might be flat or low, but many essentials are inflating - house prices, petrol prices, local body rates, insurance, electricity, etc are all suffering from inflation..

Yes, they are! And as per Stephens' post below, against what? Highly deflating incomes! It's the wrong way around. I don't subscribe to the "There MUST be 2% p.a. price inflation across the economy" - mandating price rises is not a crucial part Capitalist System in my view, it's more Totalitarian. But that aside, if incomes aren't 'keeping up' - and I don't see how they can from here - then fighting the inevitable, Deflation, seems a battle destined to be lost. So, manage it! That's what you do with a 'bad' situation - manage it. Not demonise it (" Deflation is BAD !!!"). Recognise what's coming, and work with it. But as I wrote, " a minority of people have a lot to lose".

Debt driven Deflation, once it sets in, weakens service providers and companies ability to raise prices. Jobs are lost = 25% unemployment before you know it. A vicious spiral ensues as the deleveraging process continues. That's the kind of deflation I was referring too. It's the kind of deflation central banks fear the most, not the one where the latest Samsung phone will always be cheaper tomorrow!

I hope NZ never experiences this.

Having experienced a deflationary environment firsthand, let me share some observations with you.

If there is a deflationary economy, the key is to have flexible labour markets and clear bankruptcy laws which can be implemented in a short time for a reset. Unemployment will rise, companies need to become much more cost effective and efficient.

In a deflation prices of large items fall - my rent cost fell 30-40%, property prices fell 60%. Sticker prices on most consumer items remained unchanged, however there were many discounts offered.

Most employers cut staff. I know of another company which asked staff to take pay cuts, those unwilling to take pay cuts would lose their job - so it was your choice whether to remain employed. Other companies got their staff to take unpaid holidays.

In some countries, labour markets are not flexible, so companies have a difficult time adjusting and could go into bankruptcy leading to a loss of all jobs in the company, rather than just some job losses.

As a result, many people are concerned about their job stability, (which eroded consumer confidence) so they curtail their discretionary spending such as entertainment, dining out, shopping, etc which slows economic growth further. Someone mentioned holding off buying an iPhone until they can get one at a discounted price - if you already had an old version of a smartphone, then you wouldn't upgrade due to concerns about your future employment - you are pretty much in cash conservation mode. If you didn't have any smartphone whatsoever, then you might buy a low end basic one. Businesses choose to delay investment as they face revenue pressure (except exporters)

I recall the government giving cash handouts to citizens to stimulate the economy. This brought on some unintended consequences. Some non residents who lived abroad (but were still citizens) flew back to the country to claim their government cash handout even though they had pretty much left the country permanently. I suppose it did bring some inbound tourism spending.

Deflation on a broad scale in the economy is most difficult for those that lose their jobs, and have a lot of debt outstanding which financed their consumption in the boom times (such as overseas trips, entertainment, shopping, etc). Those who own assets such as property (which falls in value) financed by debt (which maintains its nominal value) also faced financial difficulties. There were many more personal bankruptcy notices in the newspaper.

On the other hand, deflation is best for those who remain employed, and have cash in the bank, and able to purchase assets at lower prices. This was a smaller proportion of the population than the scenario above.

So on a microlevel / individual level whether deflation was good or bad depended on which end of the spectrum of the above two scenarios you were situated.

On a macro economic level, it was difficult overall as the economy adjusted, and businesses adjusted to become competitive.

CN, thank you. No one can explain it better than someone who has experienced it first hand. I admit I can only theorize it based on research I have done (Google was my friend)

This is exactly the kind of deflation that must be avoided although, I personally fear that through the use of QE post 2008, the stage may have been set on a global scale.

Retired-Poppy,

Also witnessed firsthand the residential property investment frenzy in the lead up to the subsequent deflationary period. Definitely saw some of that similar behaviour in Auckland residential real estate in late 2015-2016 ...

Deflation isn’t bad if it is for the right reasons e.g a increase in labour productivity due to technology improvements. It is a problem if people lose confidence and stop buying. IPhones are never half price the following year. Would you buy something today if you knew it was going to be on sale tomorrow?

The majority are in possession of highly deflating incomes in respect to exploding asset values.

Soaring markets helped the top 1 percent of Americans increase their slice of the national wealth to 39 percent in 2016, according to the Fed’s Survey of Consumer Finances. The bottom 90 percent of families held a one-third share in 1989; that’s now shrunk to less than one-quarter.

The current one has helped millions of people find work; it’s also benefited asset-owners far more than people who trade their labor for a paycheck. Income distribution, already the most unequal in the developed world, is getting worse. And that’s starting to influence everything from America’s spending habits to its elections.

In fact, those in the bottom quintile of wage earners in the U.S. basically haven't experienced wage growth, on a real basis, since the late 1970's whereas those in the top quintile have nearly doubled theirs.

Of course, none of this should be particularly surprising to those who are paying attention as the top quintile of earners are the only ones financially positioned to benefit from Yellen's economic recovery asset bubbles... Read more

A state of affairs that will not be addressed during Mr Orr's RBNZ governorship.

And as the fear of communism subsided in the elevated realms of our elites, then western workers became ever more screwed.

But yet,who questions GDP growth as absolutely essential to the country's economic well-being?

The concept is fundamentally flawed,as Simon Kuznetsk well knew(Google him if you need to). At some point,GDP growth will simply become impossible,as we will run out of the basic resources needed to continue down this path. I have no idea when that point will be reached,but it's high time we started to plan for it.