Policies to Fight the Risk of Deflation

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Policies to Fight the Risk of Deflation
Jeffery Amato BIS 17 November 2003
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• Disclaimer
• The views expressed are my own and are not
  necessarily those of the Bank for International
  Settlements

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Topics

• Challenges from changes in the inflation process
• The role of financial imbalances

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Key Fact 1
Inflation is lower and more stable
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Low and stable inflation is good!

• High and variable inflation have direct costs
• Stable inflation achieves other goals
• Standard view
• Changes in inflation reflect demand and supply
  imbalances
• Inflation is a sufficient statistic

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Challenge for policy
Is inflation still a reliable indicator of
underlying imbalances?
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Inflation as an Indicator

• Role as an indicator depends upon pass-through of
  demand pressures
• Indicator properties are affected by
• Credibility of monetary policy
• Dispersion of information in economy
• Competitive pressures
• Changes in these factors may have distorted the
  signal quality of inflation

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What does this have to do with deflation risk?

• Imbalances might develop even if monetary policy
  succeeds in controlling inflation
• If left unchecked, financial imbalances might
  eventually have a depressing effect on the real
  economy
• Gears of financial system may get jammed
• Period of prolonged deflation may ensue

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Implications for Monetary Policy

• Increased importance of central bank
  communication policies
• Search for alternative indicators of growing
  imbalances
• A more prominent role for financial variables??

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Key Fact 2
Greater prominence of financial booms and busts
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Background Structural Change

• Low and stable inflation
• Greater fiscal discipline
• Financial liberalisation and globalisation

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Test
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Challenge for Policy
Can monetary policy combat financial imbalances?
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Issues

1. Identification of imbalances
2. What kinds of pre-emptive policies?
3. Other challenges

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Identification of imbalances

• Are past trends a reliable benchmark?
• E.g. how to gauge changes in trend productivity??
• Joint imbalances matter
• Credit growth and asset prices (stocks, real
  estate)

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Identification of imbalances

• Are past trends a reliable benchmark?
• E.g. how to gauge changes in trend productivity??
• Joint imbalances matter
• Credit growth and asset prices (stocks, real
  estate)

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What kinds of pre-emptive policies?

• Deflationary risk -gt longer horizon
• Greater role attached to financial imbalances
• Predictive power for financial crises, which have
  large real costs

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Case Study Japan and United States

• Recent Japanese experience -gt relevance for
  assessing deflation risk
• Benchmark policies focused on inflation and
  output gap variables
• Taylor rule
• Policy rate responds to
• Inflation minus target
• Output gap
• Long-run real interest rate

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What About Other Indicators?

• Other factors may explain deviations from
  benchmarks
• Financial headwinds??
• Japan
• Structure of banking sector
• Non-performing loan problem
• United States
• A more robust financial sector?

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Other Challenges

• Political economy
• Can the central bank raise rates when inflation
  is low?
• Is interest rate policy enough?
• Again, role of communication
• Co-ordination of policies?
• Regulatory, fiscal?