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Deflationary episodes are rare, and generalization about them is difficult. Indeed, a recent Federal Reserve study of the Japanese experience concluded that the deflation there was almost entirely unexpected, by both foreign and Japanese observers alike (Ahearne et al., 2002). So, having said that deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether. Accordingly, I want to turn to a further exploration of the causes of deflation, its economic effects, and the policy instruments that can be deployed against it. Before going further I should say that my comments today reflect my own views only and are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee.

Benjamin S. Bernanke
Chairman, Federal Reserve

Washington

U.S. Dollar Purchasing Power: 1800-2010

For several decades Americans suffered the pains of rising prices. The inflationary trend has been so steady that its assumed to be part of life — ebbing and flowing like some restless sea. The prevalent attitude in government and finance is that some inflation is good — for the anticipation of future price hikes gives us motivation not to put off making purchasing decisions.

Money: An Elastic Measure Of Value

But some Americans remember the immensely painful inflation in Germany just prior to World War II when prices rose so fast that retailers changed them hourly. By the time German inflation was at it’s peak people would have to take large amounts of paper money denominated in the millions of Marks just to purchase a loaf of bread. Some apocryphal stories told of shopping trips requiring one to take along wheelbarrows of money.

Hyper-inflation has never been a problem in America, but some still worry that it could occur. Given the power of the U.S. Federal Reserve to control interest rates, and its long-standing tradition of inflation monitoring and control, runaway inflation seems an unlikely event. But there remains one monetary problem that is rarely spoken about –yet  every bit as painful and potentially destabilizing. It’s called deflation — and it’s been a reoccurring problem in the American economic system since the nation’s founding.

Today’s Deflationary Concerns

Given that there is mounting evidence of a deflation trend developing as a result of the immense financial dislocations arising from the credit markets collapse in 2008, inflationary expectations may be about to come to a end. That’s a problem — for deflationary expectations have always resulted in cash hoarding by businesses, banks and families lucky enough to remain employed, or to have cash savings.

What we know today is that inflation is not a one-way-street, for in the last 210 years there have been at least 12 periods of deflation that lasted for 2 or more years [ red entries in table below ]. Monetary control and price measures were not very reliable in the 19th century — which may account for 8 of the nation’s 12 deflationary periods occurring prior to 1900.

But during nearly two decades of deflationary  expectations between 1920 and the onset of World War II, this nation suffered a devastating depression. A depression, many economists believe to have been exacerbated by deflationary pressures that tended to keep cash in the bank and millions of Americans out of work.

What Causes Deflation

The parallels with what’s unfolding today are many — but there is, as yet, no proof that a new deflationary era is at hand. The parallels

• Cash hoarding by banks
• Cash hoarding by corporations
• Cash hoarding and/or debt retirement by individuals

The table below tracks the index of inflation [ the inflation level compared to 1967 ] as well as the increase or decrease in inflation by year. Deflationary periods of two years or more are highlighted  in red.

Consumer Price Index (Estimate) 1800-2008

Source: Federal Reserve Bank Of Minneapolis

Data: Handbook of Labor Statistics
U.S. Department of Labor
Bureau of Labor Statistics

Indexes from 1800 to 1912 and 2010 estimated by splicing the following series:

1800 to 1851 – Index of Prices Paid by Vermont Farmers for Family Living;
1851 to 1890 – Consumer Price Index by Ethel D. Hoover;
1890 to 1912 – Cost of Living Index by Albert Rees;
2010 – An estimate for 2010 is based on the change in the CPI from first quarter 2009 to first quarter 2010.