Inflation versus deflation will be an infinitive ongoing academic debate. On several occasions we have pointed at the Federal Reserve’s balance sheet which has been expanded to unseen levels and simultaneously a US government which is creating a budget deficit which will soon go through the 100 % per GDP level.
When you are a classic monetarist you can only come to the conclusion this is going to ignite a serious inflation bubble in a couple of years from now. If you look at the logic that is used by the Australian Economic school there are arguments to be made this is a recipe for deflation seen in Japan, as foreign investors to flee both the dollar and Treasuries, driving up real interest rates, pole axing any revival in risk asset prices, themselves backed by the fruits of bubble-driven mal-investment.
Both schools have valid arguments, and that is why it is so difficult to choose a side in the debate and as a consequence tailor a policy on the back of the current issues. Certainly if the risk of a deflationary environment is being discussed, and Chairman Bernanke even repeated only this week in front of a Congress hearing Committee that deflationary risks are still present, the glooming picture of the Lost Decade in Japan shows up. However two highly reputed economists, Ben Bernanke himself and Paul Krugman, have developed a draft of a policy framework to solve the problem.
Paul Krugman’s paper in 1998 starts from the IS-LM curve in looking for an answer what Japan should have done to break through its deflationary cycle. He argues that when a central bank has brought its short term interest rates to zero, it will not be enough to start using the tool of quantitative easing to solve the liquidity trap. The reason for that is that from the moment, and this is very topical at this stage, that the markets believe that all this liquidity will be taken back somewhere in the future (for example central banks that are talking about exit strategies) the extra money that is printed right now will simply be parked on accounts and will not be spend. In this case the deflationary cycle remains intact.
In order to ignite spending behaviour a central bank should give a signal to the public that it will keep on printing money in the future rather than taking this money back. By doing this it will shift deflationary expectations to inflationary expectations. Or: “The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs." (1)
The way to achieve this would be by putting upfront an inflation target which is higher than the real (negative) inflation number at that moment. To get out of this liquidity trap the central bank needs to radically change expectations to the notion that there is no exit strategy, at least until inflation is appreciably higher – not just inflation expectations, but inflation itself. Only then would the commitment to higher inflation be credible, with the central bank not just talking the reflationary talk, but walking the reflationary walk, turning deflationary swamp water into reflationary wine.
This was Krugman’s advice towards the Bank of Japan in the late 1990s. Unfortunately they were not followed up by the central bank until in 2001 they applied his policy advice to a certain extent. In stead of setting an explicit higher inflation target it committed itself to a policy where they would continue with QE until year-over-year core CPI moved above zero on a "stable" basis. This is a light version of what Krugman initially recommended and it would still take five more years before the deflationary cycle was broken.
Then there is Mr. Bernanke who did extensive academic research on the issue of deflationary pressures and reflected his findings in one of his most important speeches in November 2002 “Making sure it doesn’t happen here.”
His idea was that the BoJ should set itself a price level target (PLT) in stead of an inflation target (IT). The difference is that IT does not define the future path of the price level. This can result in a costly uncertainty for the economy. PLT reduces the future price level uncertainty. The question remains though whether this would come at the expense of increased macro economic instability.
The major problem with IT is that it does not require a credible commitment to long-run stability in the price level. In practical terms, shocks to the price level under IT are simply accommodated and as a consequence not reversed. And uncertainty around price stability is a major concern for consumers when they enter in mortgages for example.
PLT takes this uncertainty away as the central bank in question explicitly commits itself to a certain price level target number. (2)
Mr Bernanke argues: “to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.) Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap. The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place.
A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation." (3)
In this thesis Mr. Bernanke is counting on the communication skills from a/the central bank to create a clear difference between on the one hand a one-time re-flation to adjust a deflated price level back to levels in case there would not have been a deflationary cycle and on the other hand the central banks long term inflation target. Apart from the moral influence of a central bank to realise this perception change in the market he was also counting on a good interaction between the monetary and fiscal authorities to achieve this goal. Meaning one needs a government who is willing to apply a lose fiscal policy for a number of time together with a central bank who is willing to expand its balance sheet unlimited.
He continues: “My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt – so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.
Under this plan, the BOJ's balance sheet is protected by the bond conversion program, and the government's concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but – because the BOJ purchased government debt in the amount of the tax cut – no current or future debt service burden has been created to imply increased future taxes.
Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices. The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about 'broken' channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank "lacks the tools" to reach a price-level or inflation target.
Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.
Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example. The BOJ's purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption. More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations.
Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government's fiscal position." (4)
As far as the US concerns to a certain extend this is already happening. The Federal Reserve expanded its balance sheet considerable and the US Treasury is creating a mountain of debt (USD 1.8 trillion by the end of the year). The deflationary pressures at this moment are not yet that deep as was the case in Japan, but we are only the midst of the deleveraging process. As a result the US will stay in some sort of a liquidity trap for a while and will be the only party responsible for credit demand.
The question remains what will happen if the US consumer does not resume spending. In this case it is clear that Chairman Bernanke will be willing to go and use this extreme powerful tool. It will be like walking over thin ice and there is a possibility that the next generations will be paying a very high price for this (to the extent that we all are not already paying this), but the Fed Chairman made it clear in his title of his speech: "Making Sure 'It' Doesn't Happen Here" (5)
(1)"Japan's Trap," http://web.mit.edu/krugman/www/japtrap.html
(2) See also Donals Coletti and Rene Lalonde “Inflation targeting, Price level targeting and fluctuations in Canada’s terms of trade”, Central Bank of Canada, Winter 2007-2008
(3)http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
(4) See also Ben Bernanke, Essay “Japanese Monetary Policy: A Case of Self-Induced Paralysis." Princeton University, December 1999.
(5) The article is also inspired on thoughts from Paul McCulley, MD at Pimco
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