The Fed focuses on the wrong economic danger.

Last June, the Federal Reserve quietly released a discussion paper that garnered little attention in the mainstream press but created a minor stir on Wall Street and in the rarefied world of academic economics. The paper, titled “Preventing Deflation: Lessons from Japan’s Experience in the 1990s,” was nominally about exactly what its title suggested: how the persistent deflation and economic stagnation that has followed Japan’s late-’80s bubble could have been avoided. More broadly, the paper was widely seen as a justification of the Fed’s approach to fighting the recession that followed America’s own boom years. According to the Fed’s researchers, Japan could have saved itself a decade-long bout of stagnation had the country’s central bank, the Bank of Japan, shed its caution and reduced interest rates more aggressively in the early ‘90s. As it happens, this fast and furious approach to cutting interest rates was exactly the one the Fed had adopted. The paper’s message couldn’t have been clearer: Japan had been caught flat-footed; the United States would not make the same mistake.

At the time, talk of deflation—commonly defined as a period of falling average prices—was generally accompanied by the sort of bemused detachment with which people discuss horrific but exceedingly remote possibilities, like the Earth being struck by an asteroid. Most economists viewed Japan as a lone anomaly in the annals of postwar economic policy-making, the exception that proved the rule—the rule being that deflation had been banished to the realm of economic prehistory. But, as the inflation rate (that is, the rate at which average prices increase) has continued to fall in recent months, suddenly the possibility of deflation doesn’t seem so remote. To the contrary, the world’s economic commentariat is increasingly preoccupied by it. Phrases such as “deflation concerns” and “deflation risk” have begun popping up all over the financial pages. A recent headline in Financial Times reported, “DEFLATION RISK: INVESTORS ARE PREPARING FOR A PHENOMENON THEY HAVE NOT SINCE THE 1930S.” The normally light and upbeat “Personal Journal” section of The Wall Street Journal recently ran an article asking, “ARE YOU READY FOR DEFLATION?”

And so the Fed, while continuing to maintain that the risk of deflation is “extremely small,” has nonetheless begun emphasizing its determination to guard against it. On November 21, 2002, Fed governor and former Princeton economist Ben Bernanke told the National Economists Club in Washington, “I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States.” The risk of falling prices had so firmly embedded itself in the minds of Fed officials that, in his April 30 testimony before the House Financial Services Committee, Fed Chairman Alan Greenspan allowed that, “with price inflation already at a low level, substantial further disinflation would be an unwelcome development.” This was taken to mean that the Fed would do whatever was necessary to avoid “further disinflation” (i.e., inflation falling to the point that it risks turning into deflation).

The problem is that the measures the Fed uses to fight deflation—lowering short-term interest rates, for example—are the same ones that, sooner or later, lead to inflation. The assumption underlying the recent commentary from Fed officials and the point laid out in the “Preventing Deflation” paper is that deflation is much, much costlier than inflation, which would make this trade- off acceptable. And, on the face of it, that contention seems plausible enough. In a true deflationary spiral, the rising value of the dollar can price people out of jobs, leading to massive unemployment. It can also encourage people to hoard money rather than spend, which depresses demand and costs additional jobs. And deflation increases the value of people’s debts, which can lead to a wave of defaults. Worse, these trends tend to reinforce one another, creating a vicious cycle in which rising unemployment undercuts demand, and falling demand further increases unemployment. Before Japan, the last time the world had seen a persistent spell of deflation was the Great Depression. Average prices in the United States dropped 25 percent between 1929 and 1933, while industrial production fell by 50 percent and unemployment shot up to 25 percent.

And yet, when you look closer at the analogies to Japan and the Depression, as well as the other deflationary episodes throughout history, all of a sudden the risks don’t seem so great after all. Depression-style deflationary spirals should indeed be avoided. But the mere fact that average prices are falling does not a deflationary spiral make. In fact, throughout much of history, falling prices have happily co-existed with economic growth. On the other hand, the mirror image of deflation—a period of persistent inflation, which the Fed would be forced to combat with higher interest rates—can be very damaging to the economy itself. Rising interest rates inevitably slow down everything from housing and auto sales—major drivers of short-term economic growth—to investment by business, which determines the rate at which the economy can grow in the long term. The result could be that the rising unemployment and weak economic growth of the last few years remain with us for a frighteningly long time to come. By demonizing the risks of deflation while downplaying those of inflation, our policymakers may be setting us up for just the economic stagnation they so desperately hope to avoid.

The Fed and others who worry about falling prices aren’t basing their concerns on nothing. Prices for core consumer goods—i.e., everything but food and energy, whose prices are too volatile to be reliable indicators—rose at a mere 0.9 percent annual rate between October and April, and they were altogether flat in March and April (though they ticked upward slightly in May). If the economy continues to stall, the thinking goes, average prices could start to fall some time in the next year and a half.

And yet, just because the prices of many goods are falling—and may continue to do so for the foreseeable future—doesn’t mean the country is anywhere close to the kind of economic catastrophe that keeps central bankers up at night. Such fears confuse the cause and effect of a deflationary crisis. As James Grant, editor of Grant’s Interest Rate Observer, points out, economics giants such as Ludwig von Mises and John Maynard Keynes understood deflation as a condition brought about by a scarcity of money and credit in the financial system. If, for example, there was too little money relative to the amount people needed to transact their day-to-day business, then people might start rationing and even hoarding it, which would cripple economic activity. True, prices would fall under these circumstances, since fewer dollars makes each one worth more. But those falling prices would only be a symptom of the real problem, which was a collapse in the money supply.

As it happens, we can be pretty confident that today’s downward pressure on prices isn’t the result of too little money. For one thing, while average prices are indeed increasing at a slower and slower rate, individual prices are all over the map. Prices for many services, such as cable television and child care, are increasing by 5 percent per year. Meanwhile, prices for many manufactured goods, such as stereos and televisions, are falling by 5 to 10 percent per year. On average, these price hikes and price declines are roughly canceling each other out, hence the drift toward zero inflation. Second, the Fed has been aggressively lowering interest rates for almost two and a half years now, which it does by expanding the money supply. According to one broad measure, the money supply has been increasing by about 7 percent annually throughout the last few years.

There are two key reasons the prices of certain goods are falling, neither of which has to do with the money supply. First, all the equipment and information technology that companies invested in during the last 20 years— particularly during the late ‘90s—has dramatically increased productivity, enabling companies to produce the same amount of goods more cheaply than ever before. Second, that investment has led to excess capacity, meaning companies are able to produce more goods than the market can absorb. According to The Wall Street Journal, for example, the global-production capacity for automobiles stands at about 80 million per year, while global demand is about 60 million. Companies that overproduce tend to cut prices to move all their extra goods.


The Fed’s confusion of cause (a contraction of money and credit) and effect (falling prices) arises from a misreading of the two historical episodes upon which today’s conventional wisdom about deflation is based. The Great Depression, though an enormously complex phenomenon, is in some sense the better understood of the two. Despite scholarly debate about what precipitated the slowdown, there is widespread agreement that the contraction of the money supply, caused by a series of bank failures (more than 25 percent of the banks in operation in August 1929 either failed or merged with other banks in the ensuing four years) and the Fed’s inability to offset the contraction (in one view, Fed officials were relying on incorrect measures of the money supply), deserves much of the blame for its depth and duration. “Prices fell very sharply, and real interest rates rose” between 1929 and 1933, explains Carnegie Mellon University’s Allan Meltzer, author of the authoritative A History of the Federal Reserve. “But the Fed kept cutting the money stock.” When Franklin Roosevelt finally devalued the dollar in 1933—the equivalent of expanding the money supply for a currency on the gold standard, as the dollar was then—the economy rebounded. By 1936, the economy had made up all the ground it had lost between 1929 and 1933.

Japan’s experience is more disturbing precisely because it comes long after the economics profession was supposed to have learned how to avoid deflationary crises. After Japan’s stock market and real estate bubbles popped in 1990 and 1991, the Bank of Japan lowered interest rates, just as the textbooks suggest: It cut its key short-term interest rate from 6 percent in the summer of 1991 to 1.75 percent by September 1993, and then another 1.25 percent in two increments in 1995. Yet, by 1999, the Japanese economy was stuck at zero growth and prices were falling at a rate of 0.3 percent annually—a condition that more or less persists today.

The Fed, of course, has interpreted this failure as evidence that Japan didn’t act aggressively enough. But that’s just not the case. The main reason Japan has been caught in a deflationary funk for the better part of a decade is that its banking system is an absolute basket case. Banks in a normally functioning financial system would have responded to the popping of Japan’s “twin bubbles”—which left them holding scads of worthless land and stocks from businesses with no source of profit—by cutting their losses, foreclosing on the businesses they’d been lending money to, and trying to divert those loans to more productive enterprises. But, because of various bureaucratic imperatives, the banks were rarely allowed to cut off well-connected businesses and force them into bankruptcy. Indeed, it came as such a shock when the Japanese government finally allowed the zombie-like department store Sogo to go bankrupt in 2000 that—according to Akio Mikuni and Taggart Murphy, authors of the recent book, Japan’s Policy Trap—Japan’s leading newspaper “ran an enormous black-bordered headline of the type normally reserved for declarations of war or earthquakes that lay waste to whole cities.” Meanwhile, though the banks did quickly cut off many poorly connected small- and medium-sized companies, they refused to loan new ones any additional money, having been burned so badly before. As a result, the only thing lowering interest rates accomplished was to help Japanese banks continue floating money to lifeless businesses—not the most productive use of capital. More often, the banks didn’t lend money at all—they just sat on it.

Like the contemporary U.S. economy, prices were falling both in Japan in the ‘90s and in the United States in the ‘30s. But the economies only fell into a deflationary trap because policymakers could not (in the case of Japan) or did not (in the case of the United States during the Depression) stop the contraction of the supply of money and credit. Had they been able or willing to do so, the destructive deflation would have been averted.

For that matter, it’s almost impossible to find a period in history when falling prices alone contributed to sustained economic decline. Average prices fell during the recessions of 1937-1938 and 1948-1949, and again briefly during the recession of 1953-1954. But each time the economy recovered quickly. Why? According to Meltzer, as long as the money supply remains stable, the only thing falling prices do is increase purchasing power. And, when that happens, sooner or later the average person goes out and starts spending even though he or she knows that prices may fall even lower tomorrow or the next day. That has certainly been the case in China during the last five years, according to a recent paper by the Federal Reserve Bank of Cleveland. The country’s GDP has grown by an average of more than 7 percent per year during that time even though prices in the country have fallen by an average of 2 percent.

The mantra repeated again and again in the Fed’s “Preventing Deflation” paper is that the costs of overcompensating to avoid deflation are exceedingly low. As a practical matter, what the Fed means by overcompensating is that a central bank facing the risk of deflation should determine where interest rates should be based on that risk and then push them even lower. What’s more, it should keep them low for longer than it otherwise would. In general, this will lead to a period of higher-than-desired inflation once the risk of deflation passes. But that extra inflation is relatively harmless, the thinking goes, and in any case a cost worth bearing when you consider the horrible alternative.

All of which assumes, of course, that falling prices are, in fact, a horrible alternative. As we’ve established, they’re not—unless the falling prices reflect a contraction of the supply of money and credit. But no sentient central banker would ever allow that to happen. The Fed gets weekly data on the money stock—meaning, according to Meltzer, that it would require a “massive error on its part” to allow the money supply to shrink. “You couldn’t do it without knowing about it,” he says. But, even if that error somehow got made and prices began to fall as a result, it wouldn’t be so hard to correct: You just start printing money and injecting it into the economy.

In fact, not only is deflation not a serious risk today, but its mirror image, inflation—and the rising interest rates that accompany it—is. Thanks primarily to a recent orgy of tax-cutting, the projected ten-year federal deficit now stands somewhere in the neighborhood of $4 trillion. Even more alarming, according to a report ordered by former Treasury Secretary Paul O’Neill but subsequently suppressed by the Bush administration, is that the current value of the gap between all of the government’s future liabilities and its future revenue is $44 trillion. Shortfalls like this are highly inflationary since they stimulate demand for goods and services in the short run, which raises prices, and because they often get paid for in the long run by printing money. Likewise, the dollar’s recent decline—it has fallen by over 20 percent against the euro and almost 10 percent against the yen in roughly the past year—is also inflationary, since a weaker dollar raises the prices of imports.

In this context, the problem with “overcompensating”—that is, pushing short- term interest rates lower, and keeping them there longer, than you otherwise would—is that it compounds the inflationary pressure created by large federal deficits and the weakening dollar. That’s especially problematic because inflation is very difficult to root out once it gets embedded in people’s expectations: Consumers expect prices to rise quickly, so they bargain for higher wages; companies expect wages to rise, so they set higher prices. At that point, the only way to get things under control again is to raise short- term interest rates higher than you otherwise would have, which can stop the economy in its tracks. (You can of course allow inflation to continue spiraling upward. But very high inflation is devastating, since it forces people to make economic decisions based on whether they protect the value of their money rather than based on whether they’re productive or efficient.) The Fed’s decision to raise interest rates rapidly in 1994 after the economy began to recover from the 1990-1991 recession—short-term rates rose 3 percentage points in a mere twelve months—brought the recovery to a standstill. After growing by a respectable 4 percent in 1994, the economy grew by only 2.5 percent in 1995.

Worse, raising short-term interest rates also drives up long-term interest rates. This wasn’t a big problem back in 1994, since the country’s deficits were declining and the dollar was strong—both of which work to keep long-term interest rates down. But today’s large and rising deficits and the weakening dollar are having the opposite effect. According to Bank One Corporation chief economist Diane Swonk, “overcompensating” in this environment could push the yield on the ten-year Treasury note, a benchmark long-term interest rate, to above 8 percent in the next few years, from its current level of just above 3 percent. Adjusting for inflation, that means interest rates would be almost as high as they were at their peak in the ‘80s, the last time the federal deficit and the trade deficit were as large as they are now relative to the size of the economy.

Rates that high could severely dampen economic growth. Higher long-term interest rates stymie growth by discouraging consumers from borrowing money to buy goods such as homes and cars. They also discourage businesses from investing in productivity-enhancing equipment, which harms the economy over the long run. A study that Lehman Brothers chief economist Ethan Harris conducted while at the New York Fed in 1992 concluded that the U.S. economy suffered 2.5 to 3.5 percent lower potential growth during the ‘80s thanks to the decline in investment due to the higher interest rates created by the Reagan-era deficits. As a result, it’s possible that after a brief upsurge the United States could be looking at 2 or 2.5 percent growth for years to come. That sort of anemic growth wouldn’t even be enough to keep unemployment from rising.

Swonk offers a personal analogy to illustrate the problem with the Fed’s approach: “My son was in hospital this week—he has asthma. This time around, he didn’t have pneumonia, so death was not a [serious] risk. ... But they pumped him up with steroids the same way they always do ... because it’s unacceptable to risk death. As a result, I had a son who was bouncing off the walls.” She continues, “It’s what the Fed’s doing. They’re pumping up the economy with steroids. Are there consequences? Yeah. The issue is long term. And we’re living in the moment.”

The Fed’s Open Market Committee cut short-term interest rates by an additional quarter-point when it met this week—even though the previous 1.25 percent rate was already at a 42-year low and Fed officials continue to insist the possibility of deflation is remote. The move was widely expected on Wall Street, if for no other reason than that Greenspan had foreshadowed it while addressing a meeting of heads of the world’s central banks earlier this month. “We perceive [deflation] as a low probability, ... but the cost of addressing it is very small indeed,” Greenspan told his colleagues, before comparing the Fed’s decision to overcompensate against deflation risk to a “fire break,” in which firefighters clear land as a buffer for more valuable property. But the Fed is the one starting the fires. And pretty soon that could send America’s economy up in smoke.

This article originally ran in the July 7 & 14, 2003 issue of the magazine.