The Euro Area is not in deflation. Not yet, but not far. The reassuring news is that the EA is not alone to sink in a deflationary spiral. The US, the UK, Japan and the EA share the same inflation rate which has been on a downward trend for 5 years: the price level will probably not increase by more than 0.5% in 2015.
Although at a microlevel people tend to like a decrease in the price level as they feel richer, there is a general consensus in the economic profession that it leads to perverse and harmful macroeconomic dynamics that tend to depress activity and increase unemployment.
- Unexpected deflation amounts to a rise in the real rate of interest: it depresses demand
Deflation has a substitution effect: it gives an incentive for people to postpone consumption and to save. A decrease in inflation amounts to an increase in the interest rate: future good becomes cheaper. For those who are indebted, it gives them an incentive to reimburse rapidly their debt – i.e. to increase their saving – to avoid the increase in the real value of their debt. The implied additional aggregate saving is expected to depress the economy in the short-run.
It has a (likely) positive income effect: as the households are positive net creditors on aggregate, an unexpected increase in the real rate increases the value of their assets, which makes them richer and therefore consume more – provided consumption is a normal good, which is a reasonable assumption. However this effect is often expected to be small.
Deflation has a redistribution effect between debtors and creditors as it increases the value of nominal debt as we explained here. This is the Fisher channel. It means that unexpected deflation is an unexpected wealth transfers from debtors to creditors. If creditors have a lower propensity to consume than debtors, this redistribution of wealth depresses aggregate consumption and therefore aggregate demand as we explain here.
It also has a more subtle redistribution effect between people with different maturities exposure. Those who are long on the economy, i.e. those who have long term assets and short term liabilities will suffer from deflation/increase in the real interest rate as they now have to pay a higher interest rate on their debt and keep a relatively low interest rate on their long term asset. Symmetrically, those who have long liabilities and short term assets will benefit. If this distribution of maturities exposure is correlated with the marginal propensities to consume, then it can also have an aggregate effect [1].
All these effects tend to depress aggregate consumption. We now turn to the firm side, then to the feedback effects and finally to the ZLB issue.
2. Deflation will likely raise real wages
A first order effect of deflation is the impact on real wages. For nominal wages exhibit downward rigidities, deflation implies a rise of real wages over time. As a result, the cost of labor increases: demand for labor is expected to decrease as well production, employment and profits. But the income of the employed population rises.
All the effects coming from the rise in the real interest rate described on the consumer side play a similar role on the firm side. Firms will delay their investments and orders (substitution effect). Their balance sheet exposure will also impact their wealth: as an aggregate they are net debtor, so they will feel poorer, and there can be redistribution of wealth depending on their maturity exposure. All these effects plus the decrease in profits caused by the supply shock will depress investments, especially so if their access to financing is constrained by their net wealth.
3. Vicious circles: investment accelerator and job uncertainty further depress demand.
Besides there are some vicious feedback effects: as a byproduct of the decrease in aggregate consumption, firms will also decrease their investments – as we know that the first determinant of investment is aggregate demand rather than the cost of capital – which further depresses aggregate demand.
The rise in unemployment caused by depressed aggregate demand and the supply shock further depresses demand as consumption is pushed down by the increase in unemployment and job uncertainty – although it is also pushed up by the rise in real wages, the aggregate effect is usually expected to be negative, as the propensities to consume correlate with job uncertainties.
4. Zero Lower Bound
Finally and most importantly, the policy-makers are not well-equipped to navigate in a deflationary world (or even in a low-inflation environment): the Central Bank will find it difficult to boost the economy by decreasing interest rates as it is constrained by the Zero Lower Bound on the nominal interest rate – i. Indeed the latter implies that the monetary authority cannot cut the short term real interest rate – r – lower than the negative of the rate of inflation.
i >0 => r>-pi
This has two potential consequences that the academic literature is now exploring. First because of the ZLB, the Central Bank might lose its ability to smooth the economic fluctuations and in particular recessions could become longer and deeper. We come back on this issue in a paper to come.
Second, it can lead to permanent underemployment is the natural rate of return is negative. Many people have argued that the so-called natural rate of interest – the real rate of interest that would guarantee full-employment – should now be negative [2]. But the Central Bank can no longer implement negative real rate if there is deflation. The ZLB, the low inflation/deflation environment together with a negative natural rate of interest implies that the economy may be permanently stuck in underemployment. We explain the very important “Secular Stagnation” issue in a paper to come.
Conclusion
Two important points. One should keep in mind is that there is no discontinuity between low inflation and deflation. None of the channels are particular to deflation, they were also playing when there has been a decrease in inflation in the past – like the quick disinflation in the 1980s – and it also plays in the reverse direction when inflation surprisingly increases. And there is no reason to expect non-linearities in the behavior of households and firms when it comes to deflation. As for the ZLB, as the current situation suggests, it may also bind in a low inflation environment.
A second crucial point is “how afraid should we be about the contractionary forces?” It is an empirical question I still don’t have a clear answer for. To compare with recent history, many people would argue that the disinflation period of 1980s and the high real interest rates in the 1990s – partly because of the reunification – has had long term impact on unemployment in Europe. Besides high real wages are also often pointed out as responsible for the high unemployment rate in Europe. The different channels I have described suggests that these problems – and the associate underemployment situation – may only be expected to last if not worsen in the coming decade because of the fall in the inflation rate and in the natural rate of interest if we don’t do anything about it.
[1] A. Auclert, http://www.princeton.edu/~aauclert/mp_redistribution.pdf [2] https://research.stlouisfed.org/publications/economic-synopses/2015/06/05/liftoff-and-the-natural-rate-of-interest/