Does price deflation cause recession? Though deflation has become a matter of concern for the Federal Reserve, recent studies suggest that the historical and causal record is mixed. In this article, the authors use historical data for the output and price level of the United States of America, and find that a simple Granger causality approach confirms the doubts about the effect. A closer look, however, shows that while deflation alone may not cause recession, but when combined with recession, it may cause lower subsequent growth. Although interaction can lead to a downward spiral of output and prices, the authors find that they dissipate with time.
Does price deflation cause recession? Though Friedman (1969) argued that the optimal
rate of inflation should be equal to the negative real interest rate, at least for a stable
population, it is widely accepted that price deflation could be bad for real economic
activity, provided that certain conditions are met (Fisher’s debt deflation problem). The
interest in the issue goes beyond its purely theoretical aspects, of course. Deflation is
considered by many of those who study Japan’s economy as part of the explanation for
the continued stagnation since the collapse of its asset price bubble in the early 1990s
(Krugman, 2000; Eggertsson and Woodford, 2003). Indeed the potential problems
associated with deflation have recently been a matter of concern in policy circles, as shown
by the Federal Reserve’s Federal Open Market Committee press releases of June 25, 2003,
and December 9, 2003, noting that the “probability of an unwelcome substantial fall in
inflation, though minor, exceeds that of a pickup in inflation from its already low level”
(FRB, 2003). Though the language is muted, Bernanke (2003) argues that this statement
explicitly recognized the asymmetry between inflation and deflation, and officially made
the avoidance of price deflation a part of the US monetary policy.
Uncovering the links between deflation and real economic activity is far from trivial,
though, and Atkeson and Kehoe (2004) argue that the empirical link between deflation
and recession is limited to the Great Depression. Using a panel data set containing more than a century of annual observations of price inflation and GDP growth for 17 countries,
they examine five-year increments and found little correlation between the two, except
during the 1929-1933 period. Even then, they found that while all economies in their
sample experienced negative growth, only half experienced deflation, and while the
slope coefficient in a regression of growth on inflation was 0.4 for that period (i.e., a
1% deflation rate was associated with a 0.4% reduction in the growth rate), the t-statistic
was not very high even then. |
