Wednesday, March 4, 2015

No Good Deflation?

David Beckworth commented on  a Greg Ip piece in the Wall Street Journal where Ip claims that there is no such thing as good deflation.

The Ip argument is solely based upon the preference by central banks to target some short and safe nominal interest rate.   Reasoning from the Fisher effect, the higher the inflation rate, the higher equilibrium nominal interest rates.   A lower inflation rate, and particular deflation, results in lower equilibrium short and safe interest rates.   This creates less room for the central bank to stimulate the economy by reducing those interest rates.

Ip does a decent job of describing "good" deflation.   Most importantly, he describes a scenario of improved productivity for some particular product.   He also describes a scenario where the price of some imported good falls, which from a narrow perspective amounts to the same thing.   However, I would be careful in describing lower prices of imported commodities due to a world depression as a benefit to any particular country.   Of course, as a rule, lower prices are better than lower production when demand decreases.

From a Market Monetarist perspective, Ip's argument is rather an argument against having a central bank use any interest rate target, and especially the interest rate on some short and safe debt instrument, such as the overnight lending rate traditionally used by the Fed.   If such a monetary policy approach is not robust when faced by even "good" deflation, then it should go.   This is especially important with Taylor testifying to Congress in favor of them legislating his "rule."

Sumner frequently argues that it is rather nominal GDP growth that is more relevant to nominal interest rates.   If he is correct, then as long as nominal GDP is expected to remain on its target growth path, then lower inflation or even deflation due to more rapid growth in productivity or lower import prices would have no impact on equilibrium nominal interest rates.   While Market Monetarists would hardly use this characterization, if a central bank were to determine that lower nominal interest rates now are necessary to keep expected nominal GDP on target, then they should be able to manage that despite lower inflation or deflation.

However, I am not quite willing to follow Sumner in this argument.   I agree with his practical concerns regarding the price indices used to measure inflation.   And maybe expected nominal GDP growth is a better rule of thumb for making judgments regarding expected nominal interest rates than the expected rate of change in the CPI, CEP, or GDP deflator.   Still, as macroeconomists, our goal should be understanding, and expected changes in real income and expected changes in the purchasing power of money could well have different effects on real and nominal interest rates in the future.

First, let us be clear that inflation or deflation in the recent past or even right this minute is irrelevant.   It is expected future inflation that should impact nominal interest rates.   Further, it does not occur through a Fisher relation equation but rather through changes in lending and borrowing behavior.   The Fisher relationship, of course, is based upon the results of rational lenders and borrowers when they expect inflation or deflation.  However, it assumes a given real interest rate.

With good deflation (or disinflation) there is an expected favorable productivity shock.   This means that real income is expected to be higher in the future.   With consumption smoothing, that should reduce the supply of saving  today.   This would result in a a higher real natural interest rate.   Further, if the expected improvement in productivity requires the introduction of additional capital equipment, then this would tend to raise the demand for investment, also increasing the real interest rate today.   For example, if we anticipate that fracking is going to generate lots of new oil, resulting in lower oil prices, we may need to be constructing various capital goods today that will be used for this fracking.

So, while a naive application of the Fisher relationship suggests that expectations of lower prices of some good, say gasoline, will result in lower nominal interest rates, the decrease in the supply of saving and increase in the demand for investment imply a higher real interest rate, which will tend to raise the nominal interest rate.   While I am doubtful that there is any reason to anticipate that the effects must be completely offsetting, there is some offset and it is at least possible that the equilibrium nominal interest rate should rise rather than stay the exact same or fall.

Consider credit markets.   The reason for the Fisher relationship is that if prices are expected to be lower, then borrowers will be less able and willing  to borrow.  The lower ability to borrow would be due to their incomes (or revenues) being less in the future.   However, with good deflation, this is simply false.   While the prices are lower, the quantities are higher.   This is where Sumner's argument is strongest.   Of course, their is also the willingness borrow.   The larger amount of real purchasing power that must be sacrificed would seem to still to be a deterrent to borrowing.

What about credit supply?   Since lenders will be paid back in dollars that purchase more, won't this motivate people to lend more?      It would seem so, but what is the alternative?   They certainly are not motivated to hold less money, since money also will increase in purchasing power.   Perhaps it is equities?   If the price level is expected to be lower, the nominal profits should be lower too, and so equities should be worth less now.   Perhaps they will sell equities and lend more.
But with "good" deflation that isn't true.  While some prices are lower, those quantities are higher.   But surely, this is just repeating the argument that the supply of saving should decrease if expected future income is higher.

Also, I find the multiple good scenario a bit puzzling.   Do people want to lend more because gasoline will be cheaper in the future so that each dollar lent will purchase more gasoline when it is paid back?   Will people be less willing to borrow now because gasoline will be cheaper in the future and so they will be giving up more gasoline in the future when they pay the money back?   It sounds so much less plausible than when there is a single consumer good and deflation means that lenders get more of it in the future and borrowers must give up more of it.      Even so, the fact that one good among many gets cheaper already implies that any deflation is less than a similar change in productivity for "the" product of the economy.

No, in the end it is best to think of the supply of saving and demand for investment as depending on the real purchasing power received and sacrificed, so that if the real interest rate changes with no shift in the supply of saving or demand for investment, the result will be disequilibrium.  With "good" deflation, there is just good reason to expect that the supply of saving decreases and the demand for investment increases, so that the natural real interest rate increases.   That the deflation raises the real interest rate just suggest that the appropriate change in nominal interest rates is less than otherwise would be necessary.


1 comment:

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