Policies to Fight the Risk of Deflation Jeffery Amato BIS 17 November 2003

Disclaimer The views expressed are my own and are not necessarily those of the Bank for International Settlements

Topics 1.Challenges from changes in the inflation process 2.The role of financial imbalances

Key Fact #1 Inflation is lower and more stable

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

Challenge for policy: Is inflation still a reliable indicator of underlying imbalances?

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

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

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??

Key Fact #2 Greater prominence of financial booms and busts

Background Structural Change Low and stable inflation Greater fiscal discipline Financial liberalisation and globalisation

Test

Challenge for Policy: Can monetary policy combat financial imbalances?

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

1.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)

1.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)

2.What kinds of pre-emptive policies? Deflationary risk -> longer horizon Greater role attached to financial imbalances –Predictive power for financial crises, which have large real costs

Case Study: Japan and United States Recent Japanese experience -> 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

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?

3.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?