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Deflation: Determinants, Risks, and Policy Options—Findings of an Interdepartmental Task Force, April 30, 2003
Determinants, Risks, and Policy Options
Manmohan S. Kumar, Taimur Baig, Jörg Decressin,
Chris Faulkner-MacDonagh, and Tarhan Feyziog¨lu
©2003 International Monetary Fund
June 30, 2003
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Concerns of a generalized decline in prices in both industrial and emerging market economies have increased markedly since last fall. With Japan, China, and several other Asian economies already experiencing declining prices, the worry has been that deflationary pressures could deepen, and even spread more widely. This concern comes amid massive declines in global equity markets; significant excess capacity and widening output gaps; repeated disappointments over the pace of global recovery; geopolitical uncertainties; and the impact on activity of higher oil prices.
This is the second time in the past five years that widespread concerns about deflation have come to the fore—the first being during and in the aftermath of the Asian crisis. Public discussion in many countries, including the United States and Germany, has centered on risks of the onset of deflation, with increasing attention levied to such risks by policymakers. These developments are notable given that for over four decades markets and policymakers have been more concerned about inflation than deflation.
In light of the above, an IMF task force investigated issues related to the causes and consequences of deflation, the conjunctural risks in individual economies and globally, and policy options. This paper presents the findings of the task force and focuses on four areas:
Both demand and supply shocks can lead to deflation. However, with demand shocks declining prices are likely to accompany falling demand for goods and services, while with supply shocks, declining prices might be accompanied by increases in output. Nonetheless, deflation is seldom benign. Regardless of its source, deflation leads to a redistribution of income from debtors to creditors. In addition, credit intermediation can be distorted as collateral loses value. Given the zero interest-rate floor, the effectiveness of conventional monetary policy is curtailed, and this is of particular concern when output is weakening. Persistent deflation risks turning into a deflationary spiral of falling prices, output, profits, and employment.
Deflation can be costly and difficult to anticipate. Deflation was not uncommon in the nineteenth century, but even then its duration was often unanticipated. In the late 1920s and early 1930s, U.S. policymakers exacerbated deflation by underestimating its consequences and by failing to take aggressive action. In contrast, countries that exited the gold standard earlier—such as Sweden and Japan—recovered from deflation relatively quickly. Historically, deflation generally muted growth prospects, although it was mainly during the Great Depression that the most severe effects of deflation were felt.
Based on the Index of Deflation Vulnerability, the risk of an onset of deflation in a number of economies is seen to be relatively high and has drifted upward over the past several years. The risk occurs against a background of postwar low inflation rates; large output gaps; the bursting of the equity price bubble; rising banking sector stresses in some economies; and declining credit growth.
What can be done to protect against deflation?
1The Severe Acute Respiratory Syndrome (SARS) epidemic could have substantial demand side effects with adverse consequences for the pace of activity and deflationary pressures in several countries. The analytical work in this report was completed before the extent of the fallout from SARS was recognized.