In 1998, then-Fed Chairman Alan Greenspan delivered one of his famously obfuscating speeches. The rather dry subject, “Problems of price measurements,” seemed unlikely to capture much media attention. But the appearance of the word “deflation” no less than eleven times did not go unnoticed.
Was the Fed afraid of a phenomenon unseen in America for half a century, the dreaded downward price spiral of deflation, with its suffocating effect on investment and employment? This view was reinforced by the Fed’s interest rate cuts shortly thereafter. In hindsight, however much they prevented deflation, the rate cuts of 1998-1999 also fed the stock and tech bubbles that followed. But, in 1998, deflation never materialized.
In 2002, then-Fed Governor Ben Bernanke delivered what would become one of his most famous speeches, “Deflation: making sure it doesn’t happen here.” The speech presented a catalogue of responses if deflation were to menace the US economy. It can serve today as a playbook explaining many of the Fed’s recent moves, including deep interest rate cuts.
But interest rates were kept too low for too long after the 2001 recession faded, and the cheap money fuelled the real estate and credit bubbles that plague us so painfully today. Deflation, however, again was vanquished.
Today, it’s “déjà vu all over again” as the Fed returns to battle the demon deflation, for the third time in a decade. But this time the fears may be well-grounded as we move further into a recession that could become the deepest since World War II.
For investors, the policies of central banks will be critical once the recession is behind us. Obviously, inflation-targeting, the core of modern monetary policy at all major central banks, has shown its limits. It can neither prevent “irrational exuberance,” as the tech, real estate and credit bubbles have shown, nor effectively fight off deflation when exuberance switches into panic.
How to improve central bank inflation-targeting in the future? We see two main possible approaches.
The first: broaden the target beyond inflation to include asset prices in order to puncture bubbles early in their formation. Of course, implementation would be problematic. For example, what distinguishes a bubble from a healthy market evolution?
Our second idea refers to a remark in Bernanke’s 2002 speech: to avoid deflation, the Fed should try to preserve a “buffer zone” for the inflation rate when the economy weakens. Given the Fed’s deflation stance over the past ten years, this buffer zone may now be too thin. It might be wise to set future inflation targets higher than they presently stand.
Ultimately, political considerations will shape future inflation-targeting. For investors, the answer to this policy question promises either lower but steadier average returns as the central banks try to curb market excesses, or higher long-term inflation. After the inflation-free bull run of 1982-2007, neither option is appealing. Then again, market crashes and deflation fears are far worse than either of these outcomes.
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