delong: should we fear deflation?

8/14/2019 DeLong: Should We Fear Deflation?

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J. BRADFORD DELONGUniversityof California,Berkeley

Should WeFear Deflation?DEFLATION IS BACK. In the six months from October 1998 to March 1999,some 438 articles about deflation appeared in major U.S. newspapers,'compared with only 36 in the first half of 1997 and 10 in the first half of1990. For sixty years, ever since the middle years of the Great Depres-sion, deflation was a nonissue. Next to no one worried about it. Next tono one viewed a general decline in the price level as even a remote possi-bility. Now people do. And now people worry about it.

One reason to worry about deflation is that today the rate of inflationin the United States is quite low, less than2 percent per year. But that is notthe whole story.The post-Korean War1950s and the early 1960s saw mea-sured rates of inflation as low as those of today (figure 1).2 Yet back thenpeople worried not about deflation, but about inflation.3Why is it that, inthe late 1990s, inflation of 2 percent per year or less calls forth the fear ofdeflation, where it did not in the 1950s and 1960s?

The principal reason why the low inflation of the 1950s and 1960s didnot create fears of deflation was that economists in those days believed thateconomic institutions had a bias toward inflation, a legacy of the Keyne-sian revolution. Today that belief in an inflationarybias is gone, or at leastgreatly attenuated. What has happened to that belief, and to that built-in

I would ike to thankChristopherims,Alan Blinder,MenzieChinn,BarryEichengreen,RobertHall, KennethKletzer,MichaelPerelman, ndDavidRomer,amongothers, or help-ful commentsanddiscussions.1. Based on a search or articlesclassifiedin Nexis's generalnews databaseunder hekeyword"deflation";he searchwasrestricted o "major ewspapers"n the UnitedStates.2. It is commonlybut not universally greed hatgovernment tatistics uch as the con-sumerprice index overstate he true change in the cost of living. See Boskin and others(1998). I do not address uch measurementssueshere.3. See Burns 1960).

225


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226 Brookings Papers on Economic Activity, 1:1999Figure 1. Inflationas Measured by the ConsumerPrice Index,1950-98aPercent

14-1210

86-4-20 7

-2 I1960 1970 1980 1990Source Bureauof Labor StatisticsWorldWide Web sitea Changein the consumerpriceindex over the previoustwelve months (monthlydata)

bias toward inflation?4 Could it be that the bias was never as strong aswas believed, or that, if it was strong for a time, it has since been reducedor eliminated by the growth of countervailing forces?Given that deflation is back on the radar screen, should it be feared?That depends on several things. It might be that the probability of deflationis infinitesimal and that therefore we should not waste time fearing it.' Orit might be that deflation is more probable than that, but not especiallydamaging, and for that reason we should not waste time fearing it. Or itmight be thatthe costs of inflation and deflation areroughly equal-that is,our social loss function might be symmetric around zero as a function ofthe deviation from price stability. Then we should indeed fear deflation,

4. See Viner 1936),Burns 1960),andKydland ndPrescott 1977).5. PerTy(1998) concludes hatdeflation,although ery damaging,s also very unlikely.


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J. BradfordDeLong 227but not relatively: we should fear renewed inflation more than deflation, forthe price level is still rising.

I will argue that there is reason to fear deflation-and indeed to fear itmore than inflation. The probability of serious deflation or of other chainsof events that do the same kind of damage is indeed low. But it is abovezero. And there appearsto be good reason to fear that our social loss func-tion is indeed asymmetric-that deflation does more macroeconomic dam-age than an equal and opposite amount of inflation.

At one level, the reason to fear deflation is that the nominal interestrate has a lower bound at zero. Deflation-even completely anticipateddeflation-thus generates high real interest rates if prices fall rapidly, andlarge transfers of wealth from debtors to creditors if prices fall far. By con-trast, anticipated inflation does not generate abnormally low real interestrates even if prices rise rapidly, and it does not generate large transfersofwealth even if prices rise significantly.6 (However, significant unantici-patedinflation is associated with large transfersof wealth from creditorstodebtors.)

The high real interest rates that follow from deflation depress invest-ment, lower demand, and raise unemployment. Thus rapid deflationthreatens to have destructive consequences. Deflation's transfer of wealthfrom debtors to creditors diminishes the economy's ability to keep the webof credit and financial intermediation functioning. Disruption of the finan-cial system puts additional downward pressure on investment, demand,and unemployment. Here the likely size of the destructive effects dependsnot so much on the speed as on the magnitude of deflation.

There is no corresponding upper ceiling on nominal interest rates togenerate the reverse of these distortions in a time of high inflation. Thusit seems hard to argue that our social loss function is symmetric, and thatdeflation is not to be especially feared. It is easier to arguethat the chancesof deflation coming to pass are low. Yet I suspect thatthey arenot as low aswe would like to believe. Monetary policy acts with long and variable lags,and the volatility of the price level since World War II has been relativelyhigh. Taken all together, it is surely possible that an episode of deflationcould take hold well before monetary policy could react to head it off.

6. Hence economists' perennialproblem n finding social costs of moderate nflationhigh enoughto justify the degreeof aversion o it documentedn Shiller(1997). One pos-sible sourceof high costs to moderate nflationcomes fromthe interaction f inflationandthe tax system.See Feldstein 1983).


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228 BrookingsPapers on EconomicActivity,1:1999Where Has All the InflationaryBias Gone?From its beginning the Keynesian revolution raised fears of inflation.Even before the ink was dry on the first press run of Keynes's General The-

ory of Employment, Interest, and Money, Jacob Viner was warning that[i]n a worldorganized n accordancewith Keynes'specifications there would bea constant race between the printing press and the business agents of the tradeunions, with the problem of unemployment solved if the printing press couldmaintaina constant ead....7

A quarter century later, in his presidential address before the AmericanEconomic Association, Arthur Burns argued thatViner's fears had cometrue:that the post-World WarII world had become one of constant wage-push inflation.8

The fears expressed by Viner and Bums have since been developed andsharpened by Finn Kydland and Edward Prescott. These authors pointedout that a benevolent central bank possessing discretion and the ability toinduce unanticipatedshifts in aggregate demand will be greatly tempted totry to take advantage of any short-runPhillips curve to boost employmentand production.9The resulting rational expectations equilibrium will be adissipative one: workers and managers will come to expect such actionsfrom the central bank, and in equilibrium production and unemploymentwill be unaffected but inflation will be higher than desirable.

The Kydland-Prescott framework suggests two ways to counter theinstitutional bias toward inflation created by a central bank possessed ofdiscretion and concerned about high unemployment. The first is to makesure that central banks are bound by rules and do not possess discretion.10

7. Viner 1936), reviewingKeynes 1936). Vineralsoworried hatKeynes'sbook would"haveprobablymorepersuasivepower han t deserves."8. Burns 1960) believed hat heGeneralTheoryhadhadgreat nfluence, hatas a resultdeep depressionsand theirhigh unemployment ad become unthinkable, nd thatwithoutthe possibilityof high unemploymento moderateworkers'wage demands, ost-pushnfla-tion was inescapable.9. Kydland ndPrescott 1977).10. It is not completely clearwhat it means for a centralbank to be bound by rules.Does it mean that the FederalOpen MarketCommitteeshould be replacedby an expertsystem programmed y a centristmacroeconomist nd capableof runningon a PC?Doesit meanthatcentralbankers houldbe told thattheirmission is to act as if they are boundby the optimalrule?Does it meanthat we want to see centralbankers mmersed n a cul-turethatstronglycondemnsanyattempt o takeadvantage f the short-term hillipscurveas immoral?Foraninteresting iscussionof what t means npractice oran authority o tryto follow a rule,see Blinder 1998).


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J. BradfordDeLong 229This is the approach favored by Kydland and Prescott themselves. Thesecond-and this is a line of thought I associate with Kenneth Rogoffll-is to appoint central bankers who will be unconcerned about high unem-ployment.

The pattern of economic policymaking in the 1990s suggests that bothof these institutionalapproachesto diminishing inflationarybias have beenadopted.The FederalReserve today appearsto follow the rule (in the senseof Alan Blinder, although perhaps not in the sense of Kydland andPrescott) of giving first priority to attaining near price stability.12 The pastdecade has seen the flowering, and not just in the United States, of a com-mon culture of central banking in which control of inflation comes first,and always taking the long view is applauded.And some centralbankets atleast appearto have been appointed with an eye toward their relative lackof concern with-or disbelief in their own power to affect-the level ofunemployment.The result is a situationin which long-time inflation hawkscriticize the European Central Bank (ECB) for pursuing an overly tightmonetary policy,13 and in which the ECB president can announce-withinflation in the euro zone approaching 1 percent and unemploymentapproaching 10 percent-that the ECB "will act, should the need arise...to prevent either inflationary or deflationary pressures..." (italics added).

Thus it appears that attempts to reform institutions to eliminate infla-tionary bias have been successful. Or perhaps the bias toward inflation inthe 1960s and 1970s was not so much the result (as Kydland and Prescotttheorized) of a game-theoretic interaction between central bankers andthe economy, or (as Burns theorized) of an absence of fear of high cycli-cal unemployment, but instead the result of painful misjudgments aboutthe structureof the economy that were corrected after the 1970s.14

11. Rogoff (1989).12. However,attainingnearprice stability s not the FederalReserve'sonly goal underits current hair.Consider herapid oosening of monetarypolicy in the immediateafter-mathof the stock market rashof 1987, in a successful attempt o prevent ignificant ealrepercussions, r the very low (less thanzero) real interest atepolicy pursuedby the Fed-eralReserve n 1993,inpart oprovide upport o legislativeproposalsor deficitreduction.13. TheEconomist's March20, 1999, lead editorial ondemnedECB headWimDuisen-berg'sclaim "that interest] atesare 'historically ow'... [as] trueof nominalrates,but notof real ones-the kind of mistake or attempt o mislead)you mightexpectof a politician,but not a centralbanker."14. See Sargent 1999), DeLong(1997b).


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230 Brookings Papers on Economic Activity, 1:1999WhyWe Should Fear Deflation: EconomicHistoryIn the early 1920s most economists treated inflation and deflation asroughly symmetric. . . evils to be shunned. The individualistic capitalism of today, preciselybecause it entrustssavings to the individual nvestor and production o the indi-vidual employer,presumes a stable measuringrod of value, and cannot be effi-cient-perhaps cannot survive-without one.'5

Inflation was feared because of its effect on the distribution of incomeand wealth. Deflation was seen as dangerous because entrepreneursnec-essarily held long positions in real assets and short positions in nominalassets:

... the business worldas a whole mustalwaysbe in a position whereit standstogain by a rise ... and to lose by a fall in prices.... [The] regimeof money-contract orces the world always to carryabig speculativeposition [that s, to belong real assets], and if it is reluctant o carry his position the productiveprocessmust be slackened.... Thefact of falling prices injures entrepreneurs;conse-quently thefear of falling pricescauses themto protectthemselvesby curtailingtheiroperations;yet it is uponthe aggregateof their ndividualestimationsof therisk, and their willingness to runthe risk, thatthe activity of productionand ofemployment mainly depends... 16In other words, the fact of falling prices bankrupted entrepreneurs,and

thereforethe fear of falling prices led them to unwind theirpositions, closedown productive operations, and reduce output and employment.'7

15. Keynes(1923, p. 45).16. Keynes(1923, pp. 40-42).17.AlthoughKeynes'spositionwas theconventionalwisdom, hereweredissenterswhodid not feardeflation, ome of whom ndeed hought hat t was a healthy conomicprocess.Knut Wicksell arguedthat anticipateddeflationarypolicy should have no real effectsbecause t would havebeen taken nto account x ante n contracts see Boianovsky,1998).Wicksellhastened o admit hat nthe realworlddeflationdidhaverealeffects.He calledforthe Swedishgovernmento take steps to indexall contracts-includingreservedeposits.Itis not clear whetheror how he proposed o index cash. Still others, ncludingLionel Rob-bins, Joseph Schumpeter, nd U.S. TreasurySecretaryAndrewMellon, argued hat peri-odic deflationswere necessary oreconomicgrowth.Anyonecould makemoney duringaperiod of inflation. Only deflationcould determinewhich entrepreneurswereunskillful.Their bankruptcywould release factors of production hat could then be reemployedbyother,more skillful entrepreneurs uring he next boom, thus raisingproductivity nd iv-ing standards see Robbins, 1934). This line of thoughthad remarkably road nfluence.Tracesof it are evident in the passages of JacobViner'sreview of the General Theory nwhichVinerargues hatKeynesian olicieswillretardong-runproductivity rowthbylead-ing to large amountsof "low quality" mployment Viner,1936). For a more generaldis-cussion of this line of argumentee DeLong (1997a).


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J. BradfordDeLong 231The coming of the Great Depression, however, shifted the balance of

economists' fears from inflation toward deflation. After the depression anear consensus believed that deflation was deeply dangerous and to beavoided at all costs. Because nominal interest rates could not drop belowzero, the economic system had too little flexibility to adjust to the kind ofshocks that had caused the depression. What those shocks were remainsin dispute, for economists' analyses of the root causes of the depressionwere (and remain) widely divergent. Nevertheless, almost every analystplaced general deflation-and the chain of financial and real bankruptciesthat it caused-at or near the heart of the worst macroeconomic disasterthe world has ever seen.Their analyses focused on different channels. Irving Fisher stressed thatpast deflation meant bankruptcyor near bankruptcyfor leveraged operat-ing companies and nearly all financial institutions; he stressed the cumu-lative increase in real indebtedness that followed from deflation giventhat nominal interest rates could not fall below zero. 18 Friedman andSchwartz stressed the harm to banks' balance sheets from the reducednominal value of collateral and from debtors' diminished ability to ser-vice loans. The resulting financial sector bankruptcies and banking crisesled to sharp rises in the ratios of reserves and of currency to deposits,lowering the money stock and aggregate demand in the absence of anadequate Federal Reserve response. '9 Once again the disruption could besidestepped if nominal interest rates could become negative, allowing aportion of nominal debt to be written off when prices fell.

PeterTemin focused on rising risk premiumson corporatedebt between1929 and 1933: a deflation-driven deterioration n corporate balance sheetsincreased risk and drove a wedge between low short-term interest rateson safe assets like government bonds and high long-term interest rates oncorporate debt.20The fear that deflation had or would soon put debtor

18. Fisher (1926, 1933). Fisher's languagealso tells us incidentallyhow the workingconditionsof economicsprofessorshavechanged:". . . during he last threeyearsin par-ticularI have hadat leastone computer in those days, a personhired o perform alcula-tions] in my officeworkingalmostconstantlyon this problem...." (Fisher,1926, p. 497).19. Friedman ndSchwartz 1963). Theythus place theiremphasison the occurrenceof bankingcrises andon the failureof the FederalReserve o stemthem by conductinganappropriately xpansivemonetarypolicy, focusing on the decline in the nominalmoneystock rather hanon the decline in pricesand economic activity thatdestroyedbankbal-ance sheets.20. Temin 1974).


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232 BrookingsPapers on EconomicActivity,1:1999enterprises underwater and potentially trigger a scramble among credi-tors to be first in line upon liquidation made it hard for lenders to envi-sion lending more to enterprises, even though extremely low interest rateson government debt had lowered the opportunitycost.

Barry Eichengreen added an international perspective, writing of thefear that countries would depreciate their currencies and how this fearforced country after country to adopt deflationary policies to reduce theprice level and shrink the money supply.2' Since nominal interest rates forcurrencies perceived likely to appreciatecould not fall below zero, interestarbitragemeant that nominal interest rates in countries perceived likely todepreciate had a lower bound at the expected rate of depreciation plus therisk premium. Charles Kindleberger wrote of how currency depreciationexerted deflationary pressures:a small country that reduced the value of itscurrency would discover that its businesses and banks that had borrowedabroadin gold could no longer service their debts. Even though deprecia-tion did not lead the nominal home-currency price of a basket of domes-tic goods to fall, its foreign-currencyor gold price did fall, with destructiveconsequences for those who had borrowed in foreign currencies or ingold.22Christina Romer argued that even those who did not hold substan-tial long positions in equities found it advisable to cut back on spendingand increase liquidity margins in the aftermath of the 1929 stock marketcrash.23

All of these channels share common features. The first is that they allrest in one way or another on the lack of flexibility produced by the zero-nominal-interest-rate anchor. Because nominal interest rates could notfall below zero, banks could not respond to anticipateddeflationby payingnegative interest on deposits. The second is a focus on financial fragility.All the analysts cited share the belief that the interruptionof the chain offinancial intermediation had disastrous consequences for production andemployment. The effects are the same whether the disruption occurs atthe level of bank creditors (as in Friedman and Schwartz, in which it is

21. Eichengreen 1992).Eichengreen ndSachs(1985)showed hat he earliera countrygot off thegold standard ndthe further t got awayfrom ts previousgold parity, he betterit tended o fare n theGreatDepression.22. See Kindleberger1973). The same argument pplies o leveragedpositionssecuredby equities:a declinein the value of the stock market,although t is not, strictlyspeaking,a commoditypricedeflation,has thesame qualitative ffect on the stabilityof the financialsystem.23. Romer 1990).


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J. BradfordDeLong 233the increases in currency and reserve ratios that do the work), of operat-ing companies (as in Keynes's or Fisher's stories of entrepreneursunhedged against price-level declines), of the banks themselves (as inTemin, for whom the deterioration of bank debtors' balance sheets is thefirst domino), of companies with foreign liabilities (as in Kindleberger), orof consumers who no longer dare to be short in nominal terms to financetheir purchases of durable assets (as in Romer).24In all of these channelsa sharpdeteriorationin debtors' balance sheets leads to a desire on the partof both debtors and creditors to unwind their positions and boost theirliquidity, and thus to sharp reductions in business investment and con-sumer spending.Economic theory tells us that when borrowers' balance sheets areimpaired, debt contracts no longer work. An impaired balance sheet meansthat equity owners and managers have little if any net worth left, and thuslittle incentive as agents to act in the interest of their creditors. But thereis no theoretical reason why such contracts should be written in potentiallyunstable units of account, or why they should not include conditions forchanges in observed macroeconomic variables. Nevertheless, debtors doborrow and creditors do lend in nominal terms-whether it is consumersfinancing purchases of durables, banks taking deposits from households,real estate developers pledging land or other property as collateral, or com-panies borrowing from banks.

But in an environment of nominal debt contracts, nominal deflationhas the same consequences as poor managerial performance: the result-ing difficulty in servicing or repaying the loan sends the same signal ofmanagerial failure and triggers the same steps towardrestructuringor liq-uidation. Yet in this case the reason the loan goes unserviced is not thatmanagers need to be replaced or the enterprise restructured, but simplythat the price level has declined.

WhyWeShould Fear Deflation:PresentVulnerabilityDeflation was clearly dangerous in the 1930s. How dangerous is it

today? We do not know. We do not know how financially fragile the U.S.economy is today,either in terms of the vulnerabilityof entrepreneurialnetworth in the financial or the nonfinancial sector to deflation, or in terms

24. See Bernanke (1983).


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234 BrookingsPaperson EconomicActivity,1:1999of the reduction in aggregate demand that impairment of balance sheetsin either sector would cause. The U.S. economy has not experienced defla-tion since World War II. We know that economic historians blame thechannels of debt-deflation and financial fragility for the greatness of theGreat Depression. But we have no reliable evidence on the strength ofthese channels today.

Alternative Channels ThatImpair Balance SheetsIf the danger of deflation springs from its effect on net worth and

depends on the degree of financial fragility in the economy, theneconomies may well have more to fear than a decline in broad goods-and-services price indices alone. If securities and real estate holdings have beenpledged as collateral for debt contracts, then a large-scale asset pricedecline will have effects similar to those of a fall in goods-and-servicesprice indices. Both severely reduce equity net worth and the managerialstake in the enterprise. Both produce the same possibility of dissipativebankruptcy proceedings and the same reluctance on the partof lenders tofurtherextend credit to possibly impaired enterprises that makes deflationfeared.25

Is the United States today potentially vulnerable to large-scale assetprice declines in this way? In real estate, probably not; in the stock mar-ket, yes. Perhaps fundamental patterns of equity valuation have trulychanged, as investors have recognized that the equity premium over thepast century was much too large. In that case stock prices have reached(as Irving Fisher incautiously declared in the summer of 1929) a perma-nent and high plateau.26But the risk seems more substantial of a stock

25. Indeed, he deflationaryonsequences f suchassetpricedeclines s one of the expla-nationsofferedforJapan's conomicstagnationoday.InJapan,moneyis essentially ree(in nominal erms) o safe and secureborrowers,nvestments depressed,businessesreportthatno one will lendto them on reasonable erms,andfinancial nstitutions eport hatnoone will borrow romthemon reasonable erms.But economists'understandingf Japan'scurrent conomicsituation s shaky.26. See Galbraith1954).Attribution f recentstockmarket ises to reductionsnequityrisk premiums aces the problem hatfew if any investorsholding ong positions n stockstoday anticipate owerreturns han have beenrealized oniaverageover the past century.Attribution f recentstock market ises to increases n expectedearningsgrowth aces theproblem hatthe increases n aggregateproductivity rowthneededto support aster ong-runearningsgrowthare not in evidence.


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J. BradfordDeLong 235market decline on the order of 50 percent, back to Campbell-Shillerfundamentals.27

The Limits of Monetary PolicyMoreover, a deflation in broad goods-and-services prices may not be

as unlikely as we hope. The Federal Reserve's ability to offset shocks tothe price level over a one- or two-year horizon is very limited. And onceinvestors expect a deflationary shock to take hold, the fact that nominalinterest rates must be positive greatly limits the Federal Reserve's abilityto lower real interest rates as well.28

How adept is monetary policy at controlling the price level? The answerhas always been-or at least since Milton Friedman stated that monetarypolicy works with "long and variable lags"-not very.29Modem estimatesof the impact of changes in monetary policy on production, employment,and the price level continue to bear out this assessment. Authors like Chris-tiano, Eichenbaum, and Evans are very pleased when they find substantialagreement on the qualitative impact of changes in monetarypolicy (as mea-sured by the short-term interest rates that the Federal Reserve actuallycontrols) "in the sense that [the] inference is robust across a large subsetof the identification schemes that have been considered in the literature."30But the confidence intervals surroundingtheirpoint estimates are large.

Moreover, the delay in the effect of a change in monetarypolicy is largeas well: not until some eight quartersafter the initial interest rate shock hasthe impact of a change in interest rates had anything near its long-runeffect on the rate of inflation (or deflation). Using the model of Christiano,Eichenbaum, and Evans, I calculate that a 1-percentage-point upwardshock to the federal funds rate is associated with a decrease in the price

27. See Shiller (1989). How much of currentU.S. equity positionsare heldby peoplewho haveused them as collateralof one form or another?How many inancial nstitutionswould be bankrupted y a drop n the stock marketback to Campbell-Shiller undamen-tals? (Campbell-Shiller undamentalsarecalculatedby regressingex post fundamentalvalues on price-dividendandprice-earnings atios and long lags of dividends and earn-ings.) How closely have financial nstitutionsbeen monitoring hosethat have borrowedfromthem?We do not know.The lackof creditormonitoring f the hedge fundLong-TermCapitalManagement nd ts bankruptcyn the summerof 1998 do notbuildconfidence.28. See DeLong and Summers 1992).29. See Gordon 1974).30. Christiano,Eichenbaum,ndEvans(1998).


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236 BrookingsPapers on EconomicActivity,1:1999Figure 2. CumulativeEffect on the PriceLevel of a 1-Percentage-Pointncreasein the FederalFunds RatePercent

, - - - - - - - Plus 2 standard - --0.20 deviations

,,

-0.20 Estimatedffect-0.40

Minus2 standard-0.60 deviations

-0.80I I . I I2 4 6 8

Quarters fterrate ncreaseSource:Author'scalculationsbased on Christiano,Eichenbaum,andEvans(1998).

level of only about one-third of a percent ten quarters ater (figure 2). ThisVAR calculation allows for typical responses of both the economy andthe Fed to each other. A sustained change in the funds rate would beexpected to raise this effect to roughly -0.6 percent.

Even so, monetary policy remains the tool of choice for stabilizationpolicy. The lags associated with fiscal policy-presidential and congres-sional changes in spending plans and tax rates and their effects-are evenlonger and more variable than those associated with monetary policy. Butif, in the United States today,monetarypolicy has no appreciableeffect onthe rate of price change for a year and a half, and nothing close to its fulllong-run effect until two and a half years have passed, one cannot havegreat confidence in its ability to forestall a deflationary episode.

Monetary policy has more rapid effects on output. This means that theFederal Reserve perhaps has more ability to lower interest rates to offset


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J. BradfordDeLong 237the output effects of a deflationary shock than it has to head off the defla-tionary shock itself. But in a situation where investors and financial mar-kets already expect a fall in the price level, the fact that nominal interestrates cannot drop below zero significantly limits the stimulative effect onoutput that monetary policy can have.

There are also importantrecognition and formulation lags in the mak-ing of monetary policy. The Federal Open Market Committee's reliableinformation flow is at least one quarter old. Moreover, the committee isone that moves by consensus, guided by its chair, and committees thatmove by consensus rarely act quickly.31

How Large Are Price-Level Shocks?Long and variable lags in the working of monetary policy would not

be as worrisome if central bankerstoday could reliably andprecisely fore-cast what the price level will be two and a half years hence. But they can-not (figure 3). The standarddeviation of the price level two and a half yearshence is 6.6 percent for the period since 1950 (table 1). A small amountof this variation can be attributed o systematic policy. Conditioning on thelevel of inflation today (as measured by the consumer price index, or CPI)accounts for less than a thirdof the variance and reduces the standarderrorof the price level two and a half years out only to 5.5 percent. Condition-ing on both inflation and unemployment reduces the standarderroronly to5.4 percent. And conditioning on inflation, unemployment, and currentnominal interest rates reduces it only to 4.8 percent.

The most significant improvement in forecasting the price level two anda half years out results from conditioning on the identity of the chairmanof the Federal Reserve. This reduces the standard error to 3.8 percent.But fitting a step function to any process will improve the fit. It is hard toimagine what differences in the views or character of Arthur Burns andAlan Greenspan would lead the replacement of the first by the second togenerate an immediate 9 percent fall in the estimate of the price level two

31. In addition, he committeeappears o believe that short-termnterestrates shouldbe smoothed:changesin short-term nterestratesshou,ld, xceptin the rarestof circum-stances,be made n quarter-percentage-pointncrements.Fromaneconomist'sperspectivethis makes little sense. The short-term nterestrate looks like a control variable in anintertemporal aximization roblem,andsuch controlvariables an andshouldbe adjustedrapidlyandsharplywhen conditions hange.


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238 BrookingsPapers on EconomicActivity,1:1999Figure 3. Actual and Thirty-Month-AheadForecastof Inflation,1950-96aPercent

30 -Actuala

25 -

20-

15

10Forecasb

0 -1960 1970 1980 1990

Source:Author'scalculations rom FederalReserve data.a. Seasonally adjusted.b. Fittedfrom a regressionof thirty-month-ahead hanges in the seasonally adjustedconsumerprice index on the past twelvemonths' nflation, he unemployment ate,andthe federal funds rate.

Table 1. Standard Errors in Thirty-Month-AheadForecastof InflationaStandard error ofVariables included in theforecast regression the equation (percent)None 6.6Past twelve months' inflation rate 5.5Past twelve months' inflation rate, capacity utilization rate 5.4Past twelve months' inflation rate, unemployment rate 5.3Past twelve months' inflation rate, unemployment rate, federal funds rate 4.8Past twelve months' inflation rate, unemployment rate, ten-year

Treasuryrate 4.8Past twelve months' inflation rate, unemployment rate, identity of

Federal Reserve chair 3.8Source:Author's calculations from FederalReserve data.a. Residualstandarderrorsfrom a regression(using monthly data) in which the thirty-month-ahead ercentage change in theconsumerpiice indexwas the dependentvariable.


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J. BradfordDeLong 239and a half years out. It strains credulity to believe in a 26 percent effecton the price level from any Fed chairman,even G. William Miller.

Nevertheless, even a standarddeviation of 3.8 percent tells us that-ifin fact the assumption of a normal distribution applies to these data-thereis one chance in twenty that the price level two and a half years hencewill be more than 7%percentagepoints higher or lower than currently fore-cast. At currentrates of inflation, an unanticipated fall in the price levelof more than 5 percentage points (that is, well into deflationary territory)before the Federal Reserve can react seems to be an event thatwould hap-pen once every forty years. Is this a high risk of a serious deflation? No,but it is large enough to be worrisome.

Reasons for ConfidenceIs such instability enough to make a debt-deflation spiral set in motion

by unanticipated commodity price declines a serious threat? Probablynot, for several reasons.

First, it may well be that it takes a bigger economic shock to induce acertain amount of deflation than to induce the same amount of acceleratinginflation or of disinflation.32If so, calculations of price-level variabilityfrom an era of accelerating inflation followed by disinflation would be anunreliable guide to the potential for deflation. It would then take a greatercontractionary impulse to cause deflation than to cause disinflation.Attempts to estimate curvature n empirical Phillips curves tend to produceevidence of asymmetry that is convincing only to those who alreadybelieve in such asymmetry. But such tests have relatively low power.

Second, a large partof the post-1960 variance in changes in the rate ofinflation comes from the relatively narrowperiod of the turbulent 1970s.The years between 1971 and 1983 inclusive-one-third of the sample-account for 90 percent of the squared deviations of CPI inflation arounditsmean. Since 1984 the standard deviation of two-and-a-half-year-aheadchanges in CPI inflation is only a third of the full-sample standard devia-tion.33Perhaps episodes of increased variability like the 1970s oil shocks

32. Akerlof,Dickens,andPerry 1996).33. In addition, hedistributionf potential hanges npriceshasapositiveskew:a largepartof thevariancemay be contributed y a small chanceof a large ncrease n therateofinflation.In the time pathof changes n the CPI, the two oil shocks contributenfluentialobservations, uggesting that there may be such a positive skew.But 1982 saw inflationcome down veryrapidly. t is aninfluential bservationn the otherdirection.


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240 BrookingsPapers on EconomicActivity,1:1999and the breakdown of confidence in the Federal Reserve's commitment toprice stability will not happen again, either because of increasing knowl-edge about how to conduct monetary policy or because price shocks areinherently asymmetric. Surely there is reason to believe that the 1970swere a unique episode, and that the price shocks on the upside experiencedin that decade could almost never happen in reverse.

It is easy to make the argumentthat the skill with which monetary pol-icy is conducted has greatly increased in the United States, where mone-tary policymakers have been both skillful and astonishingly lucky overthe past decade. It is, however, harder to make this argumentfrom policy-making competence elsewhere in the world. In Japan producerprices were5 percent lower in the first quarterof 1999 than in the firstquarterof 1998,and over the past three months they have fallen at an annualized rate of10 percent. Estimates of the output gap relative to potential in Japan todayrange between 8 and 25 percent of current GDP. In the euro zone, asalready noted, inflation is less than 1 percent per year, and unemploymentis approaching 10 percent. These macroeconomic problems are differentfrom those of the 1970s. They are not less serious. And they do not appearto be consistent with greatly increased skill in the making of monetarypolicy.

ConclusionOur ability to forecast and control the price level over a time horizon

that corresponds with the effective range of monetary policy is low. Ourpolicy instrumentsarepowerful, but they are imprecise and subject to longand variable lags. Moreover, other sets of circumstances than a generaldecline in goods-and-services prices alone-in particular,a sharpdeclinein asset prices-could set in motion the economic processes that we fearfrom deflation.

Thus there seems to be reason to be afraid of deflation. But there is noreason-at least not yet-to be very afraid.The institutional structuresofour labor market provide us with insurance against debt-deflation, asAkerlof, Dickens, and Perry have shown.34But this insurance comes at asubstantial price: in their model the natural rate of unemployment rises

34. Akerlof, Dickens, and Perry (1996).


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J. BradfordDeLong 241substantially as the inflation rate hits zero. The relatively high price-levelvariability of the 1970s may truly be a thing of the past, not something tofear in the future.

But if the volatility of the 1970s should come again, and if deflation isnot much harder to cause than disinflation, and given that monetary pol-icy is an imprecise instrument thatworks with long and variable lags, whatthen? If the social loss function is asymmetric-if moderate deflation ismuch more damaging than moderate inflation-and if the variance of out-comes around targets is large, the conclusion is obvious: good monetarypolicy should aim for a rate of change in the price level consistently onthe high side of zero.


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CommentandDiscussion

Christopher A. Sims: This paper takes up an important set of issues. Iagree with its main point, that deflation is a danger thatis newly worrisomeand deserves our attention. I disagree with some of its specifics, however.

DeLong argues that inflation has become less of a danger in good partbecause policy has focused on controlling it, and that this focus carrieswith it an increasedrisk of deflation.I agree with this argument.In an envi-ronment of near-zero interest rates, deflation, and low or declining realactivity, policy instincts developed for an inflationary environment canbecome counterproductive.I can think of three ways this can arise.

One, obviously, is thatproportionateinterest rate changes are no longerimportant.Cutting the short-terminterest rate from 1 percent to %percenthas negligible effects, because short-term, nterest-bearinggovernmentlia-bilities and cash have become nearly interchangeable. If monetary policycontinues nonetheless to focus on manipulatinginterestrates, it is likely tobe ineffective.

A second way, the other side of the first, is that control of monetaryquantities is no longer distinct from control of interest-bearing debt. Thetwo have become close substitutes, and control of their aggregate is fun-damentally a fiscal matter, even if the central bank is taking the action.Open market operations exchanging "money" for "interest-bearing"gov-ernment debt become pointless. Open marketoperations in which privatedebt or equity securities are purchased are far from pointless, but theseinvolve government purchases of private assets, with the usual politicalramifications of fiscal policy. If private loans are purchased,certainpeopleand not others are getting money for less thanperfectly secure promises topay. They may be seen as being bailed out. If equity is purchased, the

242


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J. BradfordDeLong 243government is acquiring partial control of private companies. Centralbankers normally take pains to discount only the soundest of securities,precisely because they wish to avoid any risk of requiringfiscal backing inthe event of losses on their investments or otherwise becoming politicallycontroversial. They may even tighten their lending and discounting crite-ria in hard times for this reason, thereby precluding effective expansionarypolicy actions. And the risks they are concerned about are real, as wehave seen in Mexico, where the central bank has recently experienceddifficulties related to its discounting of private loans during a previousfinancial crisis. To take effective action against severe deflation, a centralbank needs to be able to take risks, confident that it has the fiscal backingto do so. It is worth noting that this kind of central bank strength, stem-ming from confidence in fiscal backing, is distinct from and perhaps evenundermined by simple independence from political influence or legislativeconnections. Monetary authoritiesmay hesitate to act because they see thefiscal implications of effective monetary policy measures in a deflationaryenvironment, just as fiscal authorities may hesitate to act because theycling to the notion that control of the price level is the domain of monetarypolicy.The third way in which deflation may confound monetary policyderives from the fact that, in a deflationary environment, "credibility"changes its sign, although not its fundamental meaning. To convinceinvestors thatgovernmentnominal liabilities arenot as good an investmentas real capital, the central bank and the fiscal authorities, acting together,must make them believe that future primarysurpluses will be insufficientto provide a high returnon those liabilities. This is certainly a credibilityproblem, in the sense that it requires that the public believe assertionsabout the future path of policy. But when a central bank is credible onlyin the sense that it is believed to be firm in opposition to inflation, it mayfindit difficult or impossible to promise convincingly that its expansionaryactions will be sustained rather than later reversed. Japan's central bankmay now be facing this sort of lack of credibility.

These factors imply real dangers. It may be that monetary policyauthorities are used to thinking of their role as limited to that of adjustingthe interest rate in response to inflationaryor deflationarypressures.It maybe that designers of monetary institutions (as in Europe), in the name ofpromotingindependence from the fiscal authorities,have weakened the fis-cal backing that a central bank needs in a deflationary environment. And


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244 BrookingsPaperson EconomicActivity,1:1999it may be that legislatures have learned too well the lesson that control-ling inflation should be left to the central bank. In a low-inflation envi-ronment, a disturbance that lowers the real rate of return on real assets orcreates a period of substantially declining prices could therefore trigger adisastrous set of policy reactions and inactions.

Having underlined my agreement with DeLong's main point, let metake issue with him on some of the details. The paper at several pointsassumes that inflation and deflation have impacts on income distributionofknown sign. Unemployment, of course, is especially harmful to workers,particularly lower-income workers. But inflation and unemployment areonly tenuously linked. Although a Phillips curve can be coaxed out ofstrictly bivariate U.S. data sets as a reduced-form relationship, it is a mostunreliable statistical relationship. It does not exist in most other countriesand is not a good forecasting tool even in the United States. Unemploy-ment and inflation very often move in the same direction, as they did dur-ing the 1970s oil crises and as they have done in the last few years. Mon-etary contraction probably does tend to increase unemploymenttemporarily.But monetary contraction is more likely to occur because ofthe need to end high inflation than as a spontaneous policy error at lowinflation rates that leads to rapid outrightdeflation.

Inflation itself harmspeople who hold long positions in nominal assetsand helps those who are short nominal assets. Mortgage holders benefit,for example, whereas retirees with fixed nominal pensions are hurt.Bothinflation and deflation produce real shifts of wealth, but these are not verystrongly associated with income level.

The paper argues that monetary policy does not have tight control overthe inflation rate. It displays, in figure 2, structuralvector autoregressive(VAR) impulse responses with the associated error bands, to show thatthe effects of monetary policy on the price level are slow, small, and uncer-tain. This is correct but perhaps misleading. What the figure shows is thereaction of the price level to a typical surprise monetary contraction. Itshows that such a contraction that initially raises interest rates by 1 per-centage point leads to an imprecisely estimated 0.35 percent decline inprices over the next two and a half years. But such surprise contractionstend to be short-lived, and the model is tracing out a typical path for inter-est rates subsequent to the initial rise. The figure shows the effect not of asustained 1-percentage-point rise in the interest rate, but ratherof a riseof that magnitude that within a few months has been almost completely


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J. BradfordDeLong 245reversed. The model implies that a sustained 1-percentage-point rise wouldlikely have much stronger (although still delayed) effects.

Since 1947 we have had isolated periods duringwhich inflation as mea-sured by the consumer price index (CPI) has been negative. Theseepisodes, in the immediate postwar years and in the 1980s, did not lastmore than a few months, and in the 1980s they were not accompanied bynear-zero interest rates. Dangerous deflation is deflation that is expected topersist and is therefore accompanied by very low nominal interest rates.Over longer spans of time, monetary policy can determine the average rateof inflation more precisely than it can the inflation rate on a monthly orquarterly basis from year to year. True, there is a danger of sustained,accelerating deflation. But it would require a major disturbance to theeconomy, reinforced by monetary and fiscal policy errors.Although pos-sible, such a scenario is quite a bit less likely than the kind of isolatedepisode of negative inflation, unaccompanied by very low interest rates,that a complete multivariatemodel would imply is likely.

Although it displays the response of inflation to policy-generated inter-est rate changes as found in a structuralVAR model, the paper character-izes uncertainty n forecasts of the price level using much more naive mod-els. It tells us that the standard error of thirty-month-ahead forecasts inthe naturallog of the price level is 6.6 percent and that this forecast errorcomes down only to 4.8 percent in a regression using lagged inflation,unemployment, and current interest rates. It reportsthatthis standarderrorcan be brought down to 3.8 percent if a dummy variable for the identityof the Federal Reserve chairmanis included. But in fact it can be broughtdown to 2.8 percent if a more or less standardVAR formulation-thirteenlags each, plus a constant term, of the interest rate on commercial paper,the CPI, industrial production, and a commodity price index-is used. Idoubt that the implied thirty-month-ahead forecast standard error forprices in the Christiano,Eichenbaum, andEvans paperunderlying figure 2is notably higher. The model on which this assertion is based was fit tothe period from January1950 throughOctober 1997, and the forecast stan-dard error takes into account the need to forecast future values of the right-hand-side variables with the VAR system.

Putting these two points together-that the price level is quite a biteasier to predict than DeLong's naive regressions suggest, and that theeffect of policy on the price level is quite a bit stronger than his figure 2would suggest-we can conclude that the Fed's ability to predict and con-


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246 BrookingsPapers on EconomicActivity,1:1999trol inflation is better than an initial reading of DeLong's paper suggests.If sustained deflation does occur, it will more likely reflect policy mistakesthan any inability of the Fed to counteract deflationarydisturbances.The paper provides several arguments that deflation is more dangerousor deleterious than inflation. These arguments are not essential to thepaper's main point. Hyperinflations have occurred and their consequenceshave been severe. Deflationary depressions have occurred as well, alsowith severe consequences. Luckily, it is unlikely that policymakers at anygiven time will have to choose one or the other.

In some ways the consequences of inflation and deflation seem aboutequal:-Anticipated inflation or deflation can be adapted to, so long as therate of price change is stable and exceeds minus the real rate of return onreal capital.

-Hyperinflations, in which significant portions of the economy areforced into bartertransactions, are very costly, as are deflations so rapidthat the anticipatedreal return on money moves above that on real capital.

There are some ways in which inflation is worse:-There is a classic argument that, by reducing transactions costs, slowand predictable deflation produces good effects.-It seems that high rates of inflation are harder to sustain as pre-

dictable.-Severe deflations, by making government liabilities more valuable,

deliver the policy instruments by which they can be ended: fiscal policythat steadily pumps nominal liabilities into the hands of the publicbecomes a powerful tool to increase private spending. Severe inflations areless likely to be self-limiting. They are likely to reflect and reinforce lackof confidence in the government's fiscal resources and can be ended onlyby politically difficult fiscal reform.

And there is at least one way in which deflation is worse:-At modest rates of deflation there is a danger that the real rate of

return will shift and cause a previously sustainable deflation rate tobecome disruptive.

So there are certainly asymmetries. But to my mind they do not all runin one direction, and they may well balance out toward inflation as ulti-mately the greater danger.

Although the paper does not suggest that monetary policy shouldattempt to control stock market speculation, it does suggest in passing


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J. BradfordDeLong 247that the financial consequences of a stock market crash could be similarto those of a severe deflation in the price level. This may or may not betrue. As DeLong points out, it depends on the degree to which equity assetsare standing behind nominal liabilities.

But even if it is true, that fact does not imply a case for monetary pol-icy to attempt to stabilize the value of the stock market. Monetary and fis-cal policies that produce a real return on money exceeding that on realassets are unsustainable, regardless of what we assume about price sticki-ness or asset market imperfections. While such a policy persists, the factthat it is unsustainable creates uncertainty that is a further source of dis-ruption. Rapid declines in the real values of assets accompanied by nochange in the price level, on the other hand, have negative consequencesonly because of market imperfections; monetary policy that stabilizesnominal asset values could have good or bad effects, depending on thenature of those imperfections.

If monetary policy stabilizes the stock market, it does so by transform-ing some of what would otherwise be asset price deflation into price levelinflation. At one extreme, it might be that this is all to the good. If entre-preneurs have loan liabilities only because of agency problems and fail toindex their loans to aggregate conditions only by convention, then mone-tary policy that makes nominal loans or bonds change in value with thestock market provides a service, in effect providing the missing indexationto aggregate conditions.

But at the other extreme, it might be that most loan contracts arebetween agents with different attitudes toward risk and return, with theamount of leverage in portfolios chosen deliberately. In that case, theamount of leverage in portfolios is endogenous, and policy that makes thereturn on bonds begin to mimic that on stocks will simply bring forthgreater leverage, without in the end doing anything to stabilize the finan-cial system. And of course, to the extent that there is stickiness in wagesand commodity prices, shifting some of the variability in real asset pricesfrom nominal asset prices to the general price level will be disruptive.General discussion: Robert Gordon arguedthat the paperneeded to placegreater emphasis on the difference between anticipated and unanticipatedchanges in prices. He saw unexpected price changes as the major reasonfor financial disintermediation, with the major episodes of disintermedia-tion in the postwar period having takenplace in times of high inflation. In


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248 BrookingsPapers on EconomicActivity,1:1999a similar vein, Laurence Ball argued that people with nominal assets andliabilities are primarily concerned about unexpected price changes. Henoted that, empirically, the variance of inflation is lower at low rates ofinflation, suggesting that low inflation may decrease risks. Gordon wasalso puzzled that the paper dwelled on the possibility of a stock marketcrash in a world of deflation. Recently we have seen the opposite correla-tion: a decline in commodity prices, allowing the Federal Reserve to keepinterest rates low, and a stock market boom.

Gordon suggested that the paperwould benefit from organizing the dis-cussion of various shocks, such as asset price deflation or depreciation ofthe currency, within a conventional demand-and-supply framework. Henoted that the economy can go into deflation either with a negative demandshock andhigher unemployment or with a positive supply shock and lowerunemployment. He believed that favorable supply shocks are part of theexplanation of recent favorable developments in the United States, just asan unfavorablesupply shock was responsible for the fall in output, declinein the stock market, and massive commodity price inflation in the 1970s.Martin Baily added that the distinction between demand and supplyshocks should be made in assessing the importance of downward stickywages; such stickiness need not be a problem in a deflation driven by asupply shock.

Benjamin Friedman observed that recent experience showed timeinconsistency was probably not the origin of pervasive inflation and that,even if it were, institutional changes were not requiredto stop inflation. Bynow, virtually all the developed countries have achieved low inflation andhave done so without significant institutionalchanges. In the few countriesthat did make such changes, such as moving to explicit inflation target-ing, inflation had in fact already come down. Friedmanwas also skepticalof the theoretical argumentthat principal-agent problems create a prefer-ence for debt contracts. For a typical American corporation, the value ofequity outstanding is significantly greaterthan the value of debt securities.Moreover, the predominance of equity financing seems greater for thestartups and small firms that are the hardest to monitor. Friedman wasalso unconcerned that, in the event of a deflation, people in the UnitedStates would get stuck servicing long-term nominal contracts with nomi-nal rates set in inflationary times. With the exception of the government,few in the United States borrow long term at fixed interest rates. Long-term fixed-rate corporate debt and fixed-rate mortgages are callable,


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J. BradfordDeLong 249enabling the firm or homeowner to get out of the deal if interest rates fall.Recent years have in fact seen widespread refinancing of home mortgagesas rates have fallen.In Friedman's view, the more serious risk is of an unexpected fall in theprices of assets used as collateral. Margin requirementsmitigate the poten-tial impact of stock price declines, but not of declines in real estate prices.In fact, Friedman asserted, in the United States it is easy to borrow 100 per-cent of the value of the property in most real estate transactions. He offeredthe experience of Texas in the 1980s as a good illustration of what canhappen when the value of collateral falls. That experience was a solvencyproblem, not a liquidity problem. The Texas economy was subject to a rel-ativeprice shock (oil prices fell), and local real estate prices declined.Whendebtors began to defaulton loans collateralizedwith real estate, the value ofthe real estate taken over by banks was less than the value of the loans ontheirbooks. This threatened the banks' own solvency. What happenedon aregional scale in Texas could also happen on a national scale, as seen inJapan. Friedman also observed that a rapid runup in the prices of assetsused as collateral to borrow from banks poses a difficult policy question.Monetary policy is virtually the only instrument available to control sucha runup,but asset price inflation can occur at a time when goods and ser-vices prices are well behaved and there is no reason for a policy concernedwith price stability and full employment to tighten.

Robert Hall was puzzled that the Federal Reserve does not adopt aregime in which bank reserves earn interest, since controlling the marginbetween the market interest rate and the interest rate on reserves wouldprovide the Fed with a useful policy instrument. According to Hall, thecentral bank could raise the equilibrium price level simply by lowering theinterest rate on reserves. He stressed thatcontrol of this ratewas not equiv-alent to controlling market rates: the reserve rate would not be boundedbelow by zero-the central bank could pay a negative interest rate onreserves if that was needed during a time of deflation. He believed thiswould eliminate the unstable deflationary equilibrium discussed byChristopherSims.

Sims disagreed, however, arguing that for such a policy to be effective,a way would have to be found to index currency or to prevent individualsfrom converting reserves into currency. Without indexed currency, cur-rency would dominate bank deposits if banks paid negative rates, leadingto shrinkage of the banking system.


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250 BrookingsPapers on EconomicActivity,1:1999William Nordhaus reasoned that the dynamics of disinflation are of

more concern than disinflation per se. He feared the system's response toinadequate demand would be unstable in the presence of a liquidity trap.With the nominal interest rate already at zero, a shortfall of demand wouldlead to progressively greater deflation, consequent increases in real inter-est rates, further falls in demand, and downward pressure on prices. Sucha cumulative deflationary process would be difficult to stop with conven-tional monetary policy. Nordhaus suggested, however, that if monetarypolicy operated at the longer end of the maturity structureor in equities, orwas preparedto discount commercial loans, it might still be effective. Ken-neth Arrow noted that interest rates in the Great Depression had reachedzero, and on one occasion Treasurybill rates were actually negative, as aresult of a tax gimmick. But he pointed out that the fact that the govern-ment faced a zero interest rate did not mean that corporate borrowers didalso. Hence the kinds of policies suggested by Nordhaus might have beenhelpful. MartinBaily commented that, in a dramatically deflationary envi-ronment like that of the 1930s, or perhaps Japan today, it is unclear thatbringing down the nominal interest rate by a percentage point or twowould make much difference. The Great Depression witnessed a collapseof the banking system and of confidence. Japan today has a lot of excesscapacity, and the effective marginal value of capital may be zero in manyindustries that have traditionally been the big investors. In both cases, theliquidity trap may be more a symptom of the problem than the root cause.

Baily said he had little concern about deflation in the United States atpresent. Despite Milton Friedman's warnings, the Federal Reserve hasfor many years successfully fine-tuned the economy by manipulatingshortterm nominal interest rates. It would be reason for concern aboutdeflation if interest rates were already close to zero. However, the federalfunds rate is far from zero, and Baily doubted the Fed would need to driverates that low any time soon. William Dickens agreed with Baily and wasskeptical that the Fed would ever allow deflation to occur in the UnitedStates. On the otherhand, he could imagine the ECB not reacting to defla-tionary pressures in Europe. The ECB is a new institution with an incen-tive to establish its credibility, unemployment is already high and the ECBis used to it, and the ECB is committed to price stability without any ofGreenspan's equivocation about its definition.


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J. BradfordDeLong 251References

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delong: should we fear deflation?

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