Friday, February 6, 2009 2 comments

Is deflation really a risk? IMF looks at the issue

Neil Reynolds of The Globe & Mail--you can think of him as a right-wing, hard currency, type, who often presents provocative arguments--has written an article summarizing the IMF Staff Position Note, Gauging Risks for Deflation by Jörg Decressin and Douglas Laxton. Neil Reynolds seems to share the view of the IMF and thinks that deflation is not much of a worry. Let me quote some interesting notes on deflation from the IMF report:

Deflation is typically defined as a sustained drop in the general price level. A temporary fall in the price level, for example, driven by oil prices, does not qualify. Deflation has often, but not always, been associated with poor economic performance.


Deflation was not a rare phenomenon before World War II, and the growth record during periods of deflation was not always bad. Bordo (2004) points to two episodes in the United States: 1921–29, when prices fell by about 1 to 2 percent per year, amid strong economic growth, interrupted by two mild recessions; and 1873–96, which saw sustained price declines of about 2 percent per year and solid growth. These periods illustrate that sustained deflation may not necessarily pose a problem. The reason may well be that during these prosperous years the real return on capital, and hence the equilibrium real interest rate, was quite high, driven by strong productivity growth.

However, sustained deflation makes an economy vulnerable to a sudden weakening in aggregate demand. Thus, Summers (1991) argues that real GDP growth in periods of falling prices has been less strong than in periods of rising prices, particularly in the United States. The worst cases were those where deflation came unexpectedly. The Great Depression, notably the 1929–33 period, featured overly tight monetary policy, which combined with an asset price collapse and banking panics, resulted in a debt-deflation spiral (Fischer, 1933). This was marked by widespread bankruptcies, a breakdown of financial intermediation and the monetary transmission mechanism, and sustained high unemployment.


The current setting in much of the industrialized world has common features with those deflation episodes that were accompanied by substantial output losses. In the United States, following a prolonged increase in house prices and leverage, the turning of the housing cycle is triggering bank failures and a severe weakening in net household wealth. These are leading to cutbacks in credit, which are causing reduced spending and job losses, which in turn exacerbate the collapse of asset prices. The process has spiraled out, from residential real estate to the rest of the economy, and from advanced to emerging economies.

However, important differences in comparison with the 19th and early 20th centuries make prolonged deflation less likely. Today, there are well established social safety nets, deposit insurance, and frameworks for banking crisis resolution. The debt-deflation mechanism, and the role of macroeconomic policies in averting deflation, are now better understood. Furthermore, core inflation rates remain above 1.5 percent in most countries, whereas the 19th and early 20th centuries were, overall, a period of price level decline. Nonetheless, the experience of Japan indicates that advanced economies, per se, cannot be considered immune to costly deflation.

As the quoted words recap, deflation is a sustained decline in prices and one shouldn't confuse a periodic decline in commodities such as oil as being equivalent to deflation. However, given how commodity prices--particularly wholesale prices, as opposed to retail prices--almost always drop during deflation means that we won't know what is happening until well afterwards. The IMF note takes the position that deflation is unlikely but hedges by saying it shouldn't be ruled out given the experience in Japan.

The report also contains the following table estimating deflation likelihood in various countries:

USA is near the top, which seems plausible to me. Canada is near the bottom. A big surprise to me is how UK is near the bottom. Given the massive housing bubble in the UK, I would have imagined it to be higher on the list, but perhaps the plunging currency is producing a major inflationary force(?). My feeling is that China is a big deflationary threat but this analysis doesn't seem to imply that.


2 Response to Is deflation really a risk? IMF looks at the issue

February 6, 2009 at 4:25 PM


Great find. I've been doing some research into this deflation inflation debate. I think the value investing world has an interesting article from West Coast Asset Management. Take a look at it.

Best Regards,

Miguel Barbosa
Founder of

February 7, 2009 at 2:07 PM

Can you tell me which article you were looking at? I Googled the site and I'm not sure what specific document you looked at... Thanks...

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