Deflation The newthreat

N RECENT months, concerns about the risk of globaldeflation have increased. Market commentators likeStephen Roach have emphasized the vulnerabilities in theglobal economy, and, in a speech to the Economic Club ofNew York City in December 2002, Alan Greenspan,Chairman of the Board of Governors of the U.S. FederalReserve System, noted that it was crucial to “ensure that anylatent deflationary pressures are appropriately addressed wellbefore they become a problem.” This is the second time infive years that concerns about deflation have surfaced—thefirst was in 1997 and 1998, in the wake of the Asian financialcrisis—marking a radical shift in the post–World War II pre-occupation with inflation.This time, worries have been sparked by Japan’s ongoingdeflation (see “Country Focus” on page 55), deflation inmainland China and several other Asian emerging markets,and the marked reduction of inflation rates in industrialcountries. In the industrial countries, inflation, as measuredby the consumer price index (CPI), has declined to an averageof less than 2 percent,a level not seen since the 1950s (Chart 1),while inflation rates in emerging market economies are thelowest they have been since the late 1960s.Low inflation brings substantial benefits, for example,more efficient resource allocation and a reduction in uncer-tainty. But, under today’s economic conditions—weak globalactivity, increasing excess capacity, and the lingering effects ofthe bursting of the equity price bubble, combined with ongo-ing structural changes in the world economy—low inflation(less than 2 percent or so) can increase the risk of deflation.Why is deflation harmful? There are different intensities of deflation. Deflation may berelatively mild, with aggregate price indices declining only bya percent or so, and temporary, lasting not more than a fewquarters; or it may be mild but persist for several years; or itmay be sustained and virulent, with economic stagnationand high unemployment accompanying falling prices andcosts, as during the Great Depression of the 1930s, the mostsevere deflation of the twentieth century.The first type, as seen, for instance, in Canada, Norway, andSweden in the late 1980s, might result from a cyclical defi-ciency in demand or a demand-side shock—say, a drop indemand following the bursting of an asset price bubble. In thiscase, deflation is accompanied by a slowdown or even a decline