THE RISKS OF DEFLATION AND HOW TO FIGHT THEM A Central Banker’s View on Deflation Philippe Moutot Deputy Director General - Directorate General Economics CIREM - CEPII Palais du Luxembourg, 17 November 2003

OUTLINE OF THE PRESENTATION Why is deflation costly? Why is the risk of deflation relevant in today’s world? What can monetary policy do to prevent such deflation? Where should monetary policy stop and other policies take over? Is there a risk of deflation in the euro area?

WHY IS DEFLATION COSTLY? Welfare improving deflation is possible, but rare. Sustained deflation is very costly, because 1. Deflation hampers wage and interest rate adjustments this can be captured by macro-econometric models 2. Deflation may endanger financial stability satisfactory models of the disruption of economic adjustments are not yet available

WHY IS THE RISK OF DEFLATION RELEVANT IN TODAY’S WORLD? The decline of inflation: by definition, the economy closer to deflation. This is, however, not necessarily relevant (figure 1) it has favoured the emergence of financial markets Larger financial markets are good for growth in the long run but they increase the risk of debt-deflation cycles; while financial globalisation accelerates the international transmission of shocks. These are the most relevant preoccupation for today’s central bankers regarding deflation risks. See figure 2.

WHAT CAN MONETARY POLICY DO TO PREVENT DEFLATION? Monetary policy most appropriate contribution are: To adopt strategy that provide a credible nominal anchor to the private sector. Implement this strategy in a forward-looking manner. Be prepared to adopt using the relevant instruments.

THE DEFINITION OF THE PRICE STABILITY OBJECTIVE Low enough for reaping the benefits of inflation, but sufficient to avoid downward nominal rigidities. The ECB definition: lower than, but close to 2%. Its horizon should be long enough to account for the transmission of financial shocks. A medium term orientation is preferable. Its design should stabilise long term inflation expectations at a positive level Price level targeting or medium term orientation? See figure 3.

THE NEED FOR AN ENCOMPASSING STRATEGY Taking all information into account e.g. Integrating financial flows into forecasts Analysing risks in general as well as specific scenarios e.g. Complementing forecasts with macroeconomic stress-testing Cross-checking with monetary analysis The need for robustness Money as a reflection of both trust and distrust

Directly influencing asset markets may lead to moral hazard IMPLEMENTING THE STRATEGY IN A FORWARD-LOOKING MANNER, USING THE RELEVANT INSTRUMENTS Be forward-looking! “Buying insurance” may in some occasions be useful. Directly influencing asset markets may lead to moral hazard Taking a forward-looking view of price stability is preferable Have a wide set of instruments available! Communicate wisely!

WHERE SHOULD MONETARY POLICY STOP AND OTHER POLICIES TAKE OVER? New strategic commitments cannot be a panacea Introducing a new price objective is helpful only if the new commitment is credible Financial regulation and the effectiveness of supervision are determinant in preventing and in fighting deflation/overcapacity Japan / U.S. Central banks have a direct interest in financial stability Financial market development may improve the allocation of risk and the resilience of the economy The US monetary policy more powerful because deeper financial markets made consumption more reactive to short-term interest rates

IS THERE A RISK OF DEFLATION IN THE EURO AREA? No! Neither at euro area level nor at country level! But we remain vigilant!

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Figure 3: Limits of price level targeting Overshooting the target may require entering into deflation, with the risk of impairing interest rate and wage adjustments. back