How scared of deflation were you, in 2008?

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.]

Comments

[Andy Harless]

Yes, it's clear that there's an insurance aspect to inflation spreads and that this was an important factor at the end of 2008 (as was liquidity). Bob Barro made this point at the time IIRC, cited on Greg Mankiw's blog. (I don't have the reference, but one should be able to find it on Greg's blog, and I don't recall if it was just a point Bob Barro made casually to Greg in an email or something like that or if he said publicly.)

But, dude, you have a heck of a lot of confidence on the BoC after witnessing the experiences of the BoJ and ECB (and even the Fed, which has struggled to keep the inflation rate up, though right now it appears it will succeed). Zero probability mass below 1%? Don't you think just possibly that the BoC got lucky post-2008 (e.g. by avoiding the severe housing crash that affected the US) and might not necessarily have so much success if another severe shock hits?

[Bruce Bartlett]

What I said on December 5, 2008.

http://www.forbes.com/2008/12/04/depression-deflation-velocity-oped-cx_bb_1205bartlett.html

[Nick Rowe]

Andy: Hmm. OK, I shouldn't have zero mass below 1%, even today. But it would be very small, for a 5 year average. (I actually wanted to draw the tails out a little, but I can only manage a one-way curve with Paint.)

But I do have a lot more confidence in the BoC than in the BoJ, ECB, or the Fed. Yes. The people who run the BoC are better macroeconomists, they speak with one voice, and they have the support of the government in doing what they are doing. You do not hear them say totally stupid things, like you do with people making decisions at other central banks.

[dlr]

Looking at TIPS is complicated by the fact that TIPS at or near par contain an important deflation protection option, in that principal repayment at maturity can never be below par. This is particularly applicable to small fear of a big deflation: TIPS can actually protect you from that so looking at yield spreads is going to be misleading. Initially, this seems to support the flight to liquidity argument. However, there is literature comparing 2008 newly issued and seasoned (out of the money) TIPS maturing in 2013 to isolate this deflation protection option value as a way to think more creatively about how deflation risk was being priced. Here is one example that supports the idea that there was more going on to TIPS spreads than just a flight to liquidity, and that deflation insurance mattered quite a bit:

http://www.chicagofed.org/digital_assets/others/events/2012/day_ahead/christensen_lopez_rudebush.pdf

"The results show that the deflation fear was severe at the peak of the crisis as the priced probability of a 10 percent decline in the general price level over the following five years was about one in three"

[Nick Rowe]

Bruce: thanks for that link. Though you didn't put a number on it, it is quite clear from what you wrote then that the risk of a big deflation, and how to avoid it, was at the front of your mind.

dlr: excellent comment.

[Vladimr]

Nick,

When you say you were afraid of "deflation," what exactly were you afraid of?

1. Stuff getting cheaper. (Which presumably requires some nontrivial argument to present as a bad thing, e.g. the money illusion making wages downward-rigid and leading to unemployment.)

2. The pyramid of money multiplier based on maturity mismatched accounting collapsing. (With fractional-reserve banking as the most well-known but by no means the only case -- or even the most important one in the era of government deposit insurance.)

3. Something else?

Whatever it is, do you really think "deflation" (which in most people's mind will register as simply the opposite of their everyday experience of mild to moderate inflation) is the right word that should be the central focus of public discourse?

[Tom Brown]

Vladimr, "...Stuff getting cheaper" ... you mean like hours of my time... while my nominal debts don't get any cheaper?

[Nick Rowe]

Vladimir:

1. Deflation would be a symptom of falling demand, falling volumes of trade, falling output and falling employment. Like the 1930's.

2. Plus the arbitrary redistributions of wealth, and the defaults, from non-indexed nominal debts.

[Ralph Musgrave]

Nick asks, "How scared of deflation were you, in 2008?" My answer: "not at all".

Amongst other reasons that was because in the 1800s there was on average NO INFLATION in the UK: at least the price of bread in 1900 was the same as it had been in 1800. To be more accurate, there were periods of rising prices and periods during which prices FELL. The latter did not cause the sky to fall in.

[Nick Rowe]

Ralph: what about the 1920's? A quick Google tells me that the wholesale price index fell from 300 in 1920 to 100 in 1932. And the 1920's were not good times in the UK.

[Bob Smith]

Ralph,

I think, though, that there's a difference between deflation brought about by technological change resulting in increased productivity (i.e., lower costs) and deflation brought about by decreased demand.

The 19th century saw widespread deflation as transportation costs plummeted and output increased. For the same reason, no one is too fussed by the rampant deflation in the tech sector today (in 1980, a computer with the capabilities of my $500 desktop, if it even existed, would have cost tens of thousands, if not millions, of dollars.)

On the other hand, if prices are falling not because goods are getting cheaper to produce, but because no one is buying them, that's a problem,

[Ralph Musgrave]

Nick and Bob,

Good points. My attempt at a summary herewith.

Re the 1920s, the central problem was inadequate demand (which lead to falling prices). So the central problem was inadequate demand, not falling prices as such (unless you think there’s a lot of hysteresis in falling prices, i.e. people hoard money so they can buy stuff cheaper in a year’s time).

Re the 1800s, much the same applies. I.e. in that falling prices were due to improved technology, that’s no problem (unless you think . . . same hysteresis point etc).

Conclusion: since I don’t think the hysteresis is a powerful effect (and I’ve no evidence to back that), I’m not scared of deflation in the “falling prices” sense of the word. At least prices falling at 2 or 3% a year wouldn’t be a problem. 10 or 20% could be different.

[Nick Rowe]

Bob and Ralph: some economists make the distinction between "good deflation" (1800's) and "bad deflation" (1920's for the UK, 1930's elsewhere, because of gold standard timing). But like Bob, I think it's better to see deflation as a symptom, that can come from increasing supply (good) or from insufficient demand (bad).

[Frank Restly]

Let's say you are a farmer back in the 1920's and produced as much as you could. Technological progress allow you to use mechanized equipment to plant and harvest crops more quickly than you could by hand. What happens under each situation:

Situation #1: You have no debt. Prices fall because you (and other farmers) are producing more crops than what are demanded. You end up burning crops / letting them rot on the vine. Lesson learned, next year you don't plant as many crops. You still own the farmland.

Situation #2: You borrow money against your farmland to buy the mechanized equipment to increase your production. Your nominal cost of debt remains fixed while your real cost may rise. The bank seizes your farmland after you are unable to make the payments on the debt. Now the bank has farmland that could be used to plant crops, but instead lies fallow.

When deciding whether deflation is good / bad, I think it is helpful to look at both cause (technological progress / inadequate demand) and well as outcome.

[Peter K.]

Can you please give your perspective on the debate between Beckworth and Krugman here?

http://macromarketmusings.blogspot.com/2014/09/the-love-affair-conservatives-should-be.html

Paul Krugman and Josh Barro are going after conservatives for their "new love affair with Canada". They claim conservatives are incorrect to view Canada's successful fiscal consolidation in the 1990s as evidence of "expansionary austerity." Here is Krugman:

Canadian austerity in the 1990s was offset by a huge positive movement in the trade balance, due to a falling Canadian dollar and raw material exports...Since we can’t all devalue and move into trade surplus, this meant that the Canadian story in the 1990s had no relevance at all to the austerity debate of 2010.

Actually, the Canadian story is very relevant to the austerity debate of 2010, but not in the way portrayed by most conservatives. For the Canadian story is largely about expansionary monetary policy offsetting contractionary fiscal policy. The Canadian dollar's fall was not some random event, but the result of concerted efforts by the Bank of Canada to counter the drag of fiscal austerity. This is an important story and it is not the first time it has transpired. About fifteen years earlier the Bank of England also used monetary policy to offset fiscal policy. Ramesh Ponnuru and I wrote about it these experiences back in 2012 in The Atlantic:..."

[Nick Rowe]

Peter: [I found your comment in the spam filter.]

I basically agree with David. Monetary policy *can* offset fiscal policy, and US conservatives need to get that, and support a better monetary policy.

But given Paul's perspective, that the ZLB is a constraint on monetary policy, you can see why he would argue that Canada 1995, where the Bank of Canada had lots of room to cut nominal interest rates, and did, is not the same as the US recently.

What is so ironic in all this is that it was a Liberal Canadian government that cut spending in the 1990's. And the current Conservative Canadian government, which many lefties accuse of being extremely right wing, that did a textbook New Keynesian fiscal policy in the recent recession. They increased government spending, especially on "infrastructure investment". They deliberately ran a deficit, even though there had developed a strong popular consensus, since the 1990's, that deficits are bad things and we mustn't throw away all our hard-earned fiscal rectitude. And then when the Bank of Canada lifted off the ZLB, they started tightening again. Straight from the NK playbook! (Though also, straight from the orthodox micro textbook too, because it makes sense to borrow and invest more when you face very low (or negative) real interest rates.)

[Peter K.]

Thanks for your response!

[Lorenzo from Oz]

How scared? Almost none. Because (1) I had little understanding of monetary matters back then and (2) I live in Australia. I assumed the exchange rate would take the shock, as it did in 1997 with the Asian Crisis, when most of our major Asian trading partners all had problems all at once. And we hadn't had a recession in 17 years, and you get out of the habit of being fearful.

[SvN]

Of course, in some countries the central bank is explicit about their deflation worries.

For example, the Bank of England has long published their subjective probability distributions for inflation (and GDP growth). Quarterly. For example, you can find the November 2008 distributions at

http://www.bankofengland.co.uk/publications/Documents/inflationreport/ir08nov5.ppt

As you can see, they thought the risks of deflation were small (I'm eyeballing it at around 15-20% two years out.)

Then again, a number of economists have crunched the numbers on their probability forecasts and found that they don't do very well.....

[TallDave]

I basically agree with David. Monetary policy *can* offset fiscal policy, and US conservatives need to get that, and support a better monetary policy.

It's a tough road to hoe, let me tell you. They all view this in terms of governments monetizing their ever-increasing debt. Sigh.

[Min]

Nick Rowe: "I'm trying to remember that lovely quote from Keynes."

"In the long run we are all deflated"?

;)

[Min]

Being in the US, in '08 after the bank bailout passed in Congress, I was not really worried about deflation. A Republican administration, of all things, was pumping money into the economy. I would have preferred a Main Street bailout, but you take what you can get. It was in '09 that I began to worry, maybe not about deflation, but about low inflation and long term stagnation, because a Democratic administration, of all things, was not committed to economic recovery.

[Nick Rowe]

Min: no, it was about fears, and nightmares. Damn, my memory has gone.