Illustration by Stephen Cheetham
Illustration by Stephen Cheetham

The aggressive stimulus programs undertaken by the Federal Reserve have partly been motivated by a growing fear of deflation.

About a decade ago, 12 of the Fed’s top economists were assigned to a study of deflation in Japan. They concluded that the best way to combat chronically falling prices was to initiate a huge stimulus, and quickly. That’s exactly what the central bank has done.

The Fed worried that deflation would impede its efforts to create inflation-adjusted real interest rates that were negative as a way to encourage people to borrow. Because central-bank target rates can’t go below zero, real rates are always positive when price indexes are falling. This has long been a problem in Japan.

Yet because the consumer-price index is still rising, the real federal-funds rate has been negative since shortly after the Fed cut the nominal rate to essentially zero. This hasn’t spurred a surge of borrowing. Just consider the excess reserves of $1.7 trillion on the commercial banks’ accounts at the Fed.

Furthermore, the Fed is concerned that if chronic deflation sets in, it will be unable to raise interest rates. That, in turn, means the central bank would have no room to cut rates as it would prefer when the next bout of economic weakness occurs.

Buyers’ Expectations

Central bankers also fear deflationary expectations, which translate into buyers delaying purchases in expectation of lower prices, exacerbating excess inventories and overcapacity, and forcing prices down. Their suspicions confirmed, prospective buyers wait even longer, and a downward price spiral develops. Despite the Fed’s alarm, this pattern hasn’t emerged in Japan, even though prices have fallen more often than they have risen in the past two decades.

The Fed is always concerned that deflation will increase the real value of debt, which would strain the economy. Debt remains unchanged in nominal terms but as prices fall, the cost increases in real terms. Under such economic circumstances, the incomes and cash flows of debtors usually fall in nominal terms and their ability to service their debt becomes questionable.

This is similar to what is happening to homeowners who can’t make monthly mortgage payments because their incomes have been reduced by job loss, pay cuts or moves to lower-paying jobs, while their mortgage payments remain fixed.

Congress and the administration also hate deflation because it reduces nominal revenue as corporate profits and household incomes fall, and taxpayers descend into lower tax brackets.

Deflation also causes the real cost of federal debt to rise, and undermines taxpayers’ ability to service and repay it. This is the opposite of inflation, which has prevailed since the 1930s, and explains why the real federal debt has risen slower than its nominal counterpart.

Some critics suggest there is a government conspiracy to promote inflation to reduce the real value of debt. In conversations with policy makers over the years, I have never heard even the slightest hint that such a policy existed. In fact, there is far more worry about the disruptive effects of inflation on the economy. Also, the ability of inflation to reduce real federal debt is mitigated by the related increases in the cost of government purchases and benefit payments.

What is the root cause of any future deflation? Aggregate price deflation results from an excess supply of goods and services compared with demand. Monetarists, influenced by the work of Milton Friedman, believe that inflation (or deflation) is always and everywhere a monetary phenomenon. That hypothesis ignores the supply-demand balance that is the foremost determinant of the money supply.

Monetary Policy

Those who hold that money is the prime mover must see the monetary authorities of the early 1940s as irresponsible idiots for allowing the money supply to explode and induce major inflation. During World War II, monetary policy was merely the handmaiden of fiscal policy.

With so much of the economy’s production then going to the military, there was limited output of civilian goods and services, far less than purchasing power in the fully employed economy. The government didn’t want to risk damping patriotic spirit by raising taxes to soak up the surplus income and finance the war effort. Instead, it resorted to selling war bonds and allowed a huge increase in the money supply. The inflationary response to this policy occurred after wartime price-and-wage controls were removed.

Furthermore, the fairly steady 3 percent annual increases in the M2 money supply in Japan in the past two decades haven’t prevented chronic deflation, even with huge increases in government debt. Both monetary and fiscal stimulus has been swamped by increased savings by Japanese consumers and subdued spending by households in the 1990s and, more recently, by the business sector.

Similarly, in the U.S., monetary and fiscal actions haven’t overcome private-sector deleveraging. Not only does economic growth remain weak, but inflation has essentially disappeared.

For the U.S., general price deflation is the likeliest scenario in future years. Fiscal-stimulus programs are shrinking as a result of the budget battles in Washington, and Congress and Barack Obama’s administration appear to be serious about containing the deficits produced by the retirement of the baby boomers.

The Fed is committed to open-ended quantitative easing until a 6.5 percent unemployment rate is reached, and as long as inflation remains subdued.

But when deleveraging ends and normal economic growth resumes, the central bank will be forced to eliminate the huge excess reserves. The current fiscal and monetary offsets to the powerful deflationary forces are temporary.

(A. Gary Shilling is president of A. Gary Shilling & Co. and the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the third in a five-part series. Read Part 1, Part 2 and Part 4.)

To contact the writer of this article: A. Gary Shilling at insight@agaryshilling.com

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net