Price Deflation and Zero Interest Rates: Could It Happen in the United States?

Publication Date: October 2003

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

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Abstract:

Some analysts have raised the specter of the U.S. economy sinking into price deflation (a general decline in prices over time) and persistently stagnant growth. Although the United States has not experienced deflation since the Great Depression, the Japanese economy has now suffered from deflation for several years. These analysts argue that Japan cannot escape deflation because its monetary policy has lost its effectiveness, with short-term market interest rates that have fallen to zero. Since short-term interest rates in the United States are at their lowest level in decades and some prices have fallen, some commentators foresee the United States soon facing a similar problem.

Although interest rates are an important mechanism by which changes in the money supply affect the pace of economic activity, monetary policy would not become impotent when short-term interest rates were near zero. Long-term interest rates would likely still be positive, as is the case in Japan, and these could be lowered to expand aggregate spending. Even if long-term interest rates reached zero, newly created money could be injected into the economy in two other ways. First, it could be used to directly finance government budget deficits. Second, it could be used to purchase foreign exchange, which would boost output by making exports and importcompeting industries more price competitive, independent of the state of domestic demand. In sum, even if external forces set a country's deflationary spiral into motion, its persistence is primarily the outcome of central bank policy.

The main drawbacks to using unconventional methods of monetary policy are of a political, not economic, nature. There is a fear that unconventional methods could undermine a central bank's reputation and independence. It is also feared that the manipulation of the foreign exchange rate to undertake monetary expansions could lead to diplomatic tensions, since import-competing industries in the nations that received the increase in exports would be harmed. It could also harm third countries who are linked to one of the appreciating currencies.

In any case, similarities between economic conditions in the U.S. and Japan are questionable. At present, the U.S. economy is operating below its potential, but growth is positive. Inflation is low and has fallen, but is still well above zero. In 2002, prices rose 1.6% and, through September, they rose at an annual rate of 2.7% in 2003. To put this rate in perspective, the European Central Bank is mandated to prevent the inflation rate in the Euro Area from exceeding 2.0%. If the Federal Reserve had a similar mandate, it would presumably be tightening monetary policy at present because inflation was too high. The federal funds rate is currently low, but still has a way to go to zero. Adjusted for inflation, it is lower than overnight rates in Japan, despite the fact that the Japanese rate is near zero in nominal terms. The U.S. banking system is healthy. Unless the United States experiences some unexpected economic calamity beyond its control, it is difficult to see how deflation could emerge in the United States under current conditions. This report will be updated as events warrant.