Financial Times; Aug 21, 2002
COMMENT & ANALYSIS: America's date with deflation
By Bradford DeLong
Two years ago, at the peak of the late-1990s boom, the US economy was slightly overheated. As the unemployment rate fell to 4 per cent and below, inflation began to creep upwards, rising by between a quarter and half a percentage point each year. By late 2000 it was clear that America's gross domestic product was 1-2 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. America's level of real GDP is running 2 percentage points higher than it was in the summer of 2000. However, underneath is the extremely strong underlying productivity growth trend driven by technological revolutions in data processing and data communications. These technological revolutions have boosted potential output by perhaps 7 per cent over the past two years. Thus today America's real GDP is not 1-2 per cent above but 3-4 per cent below potential output.
How do we know this? Simply look at the unemployment rate: today America is producing 2 per cent more than it did two years ago, and is doing so with an unemployment rate not of 4 per cent but of 6 per cent. 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 US economic growth will be positive, but will be significantly less than the rate of growth of potential output. In 2003, the consensus forecast is for US economic growth to be about 3.5 per cent - equal to the rate of growth of potential output, but not enough even to begin to close the output gap.
With production substantially below potential output, there is downward pressure on US inflation. We have already seen the US inflation rate nearly halve in the past two years. This downward pressure is not expected to lessen for at least the next year and a half. That means that by the summer of 2004 the US will have an inflation rate - at least as measured by the GDP deflator - that is less than zero. The US 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 4 per cent a 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 4 per cent a year. When there is deflation, the central bank cannot make businesses such offers that they are unlikely to refuse: at a deflation rate of 1 per cent a year, the real value of businesses' cash on hand grows by 1 per cent a year even if the short-term nominal interest rate is as low as it can go.
The consensus forecast for the US economy over the next two years is not a pleasing one. Few - if any - believe that an unemployment rate of 6 per cent 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 $800bn in real production of goods and services.
More important, 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 US Federal Reserve of its power to stimulate the economy. Today's GDP-deflator inflation rate is about 1 per cent a year, meaning that today's federal funds rate target of 1.75 per cent per year corresponds to a short-term real interest rate of 0.75 per cent a year. If the US price level in two years is not rising but falling at 1 per cent a year, it will be impossible for the Fed then to pursue a policy as stimulative as the one it is pursuing now.
It is in this context that the Fed's failure to cut interest rates so far this year is puzzling. If 1.75 per cent was the appropriate interest rate last winter, when stock indices were 20 per cent higher than they are today, it is hard to see how it can be the appropriate rate today.
Furthermore, if 1.75 per cent was the appropriate interest rate 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, it is unlikely to be so today. And if the Federal Reserve wishes - as it surely does - to preserve its power to offset and neutralise any future contractionary shocks to the economy, the current inflation rate is already dangerously low and already leaves it with remarkably little room for action.
None of this means the US economy is about to run aground. But anyone who has sailed a yacht knows that it is not enough to be sufficiently far from shore to have 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 co-operate.
The first rule of prudence - in yachting and in monetary policy-setting committees - is to keep away from situations in which one or even two adverse shocks will cause severe difficulties.
It is thus disturbing that the consensus forecast seems to paint a picture of the US economy two years hence in which production remains substantially below potential output, and in which slight deflation has taken hold and robbed the Fed of its power to offset adverse shocks. The current course is one that prudent sailors would be scrambling to change.
The writer is professor of economics at the University of California at Berkeley