In normal times, like today, or 2004, my subjective probability distribution for the average annual inflation rate over the next 5 years looks something like this:
The Bank of Canada tries to keep inflation between 1% and 3%, and targets the 2% midpoint of that range. In any one year, inflation will rarely fall below 1% or rise above 3%. And if we take a 5 year average of annual inflation rates, that is very unlikely to happen. And it is unlikely the Bank of Canada will change its inflation target in the near future, and if it did change the target it would probably give us a few years advance warning.
It is hard to remember what we thought in the past. It is especially hard to remember the things we were scared of in the past, when those things we were scared of happening did not in fact happen. Who wants to remember their silly nightmares?
But I do remember being scared in 2008. And one if the things I was scared of was a 1930's style deflation, where the price level fell, a lot. How far could the price level fall? Could I totally rule out a 50% fall in the price level, which would give an average 5-year inflation rate of minus 10%? (Yes, I know, I should take the geometric average.) Maybe the Bank of Canada and other central banks would totally fail to respond to the crisis, and people would lose confidence that they would respond, which would make the price level totally unanchored. If people think that fiat money is worth nothing, then it is worth nothing. And if people think that fiat money is worth everything, then it is worth everything.
That big deflation didn't happen of course. We know that now. But we didn't know that at the time.
When I was at my most scared, my subjective probability distribution for average inflation over the next 5 years probably looked something like this:
I was much less confident that I could forecast future inflation accurately. The variance increased by a lot. But all that extra variance was on the downside. My subjective probability distribution became very skewed. The mode of the distribution didn't change much; the most likely outcome was that inflation would be only a little below 2%. But the mean fell a lot. And if you are risk-averse, the mean isn't the only thing that matters. If I had been offered insurance against a 1930's style risk, I would have paid more than the actuarily fair premium. I would have paid over the subjectively fair odds to bet that deflation would happen. Someone who inferred my beliefs from the betting odds I would accept would think I had an even lower mean.
Brad DeLong has a post on the fall in US expected inflation, as estimated by the spread between real (indexed) and nominal (non-indexed) bonds. There is a big downward spike in 2008. At the trough, the implied expected inflation rate for 5 years was minus 2% per year.
Brad says that downward spike is because real bonds are less liquid than nominal bonds, and there was a liquidity crunch in 2008, so the liquidity premium increased, so we should not interpret that spread as saying people expected 2% deflation. That's almost certainly part of it. But I wonder if a big part of it was that people really were scared of a big deflation. Not that they thought it probably would happen. But they thought that the risk that it might happen was well above zero.
I thought a big deflation might happen. When I was most scared, I was very scared. I keep the pile of little bricks as a memento of my thoughts back then.
When people joked about having to eat squirrels, they were joking to cover their fear.
The job of a central bank is to provide a nominal anchor, to coordinate people's expectations on some nominal variable, so that everyone has roughly the same probability distribution with the same narrow variance. That didn't happen in 2008.
If central banks had been targeting a level path, either for NGDP or the price level, things would have been different. Because even if central banks had lost control of the ship temporarily, everyone would know that the ship would return to the original course once they did regain control. 5 year expected inflation would not change much, and 10 year expected inflation perhaps not change at all.
Perhaps that data on the yield spread between real and nominal bonds tells us all we need to know about what caused the Great Recession.
How scared of deflation were you, in 2008?
[I'm trying to remember that lovely quote from Keynes.]