Are central bankers battling a phantom menace?

New research from the Bank for International Settlements

suggests that there is little to fear from even a persistent fall in the prices of goods and services, although a sharp decline in asset prices is a different matter.

Examining a new data series that spans more than 140 years—from 1870 to 2013—and covers 38 economies, economists at the international organization for central banks have concluded that there is only “a weak association between goods and services price deflations and growth; the Great Depression is the main exception.”

Two episodes help explain why the threat of persistent deflation tops the list of things that keep modern central bankers awake at night: the Great Depression, and more recently, Japan’s “lost decades.”

Both periods seem to confirm that when prices are falling for a long time, output suffers, and the link between the two becomes self-reinforcing and chronic.

So great is the fear of deflation that it took just one month of falling prices to prompt the European Central Bank to abandon its long-held reservations about printing money to buy government debt, and announce in January the launch of a program of quantitative easing.

In Japan, a huge program of QE has also been deployed to end the period of deflation that dates back to 1998. The U.S. Federal Reserve and the Bank of England adopted similar policies to fend off the threat of deflation in the immediate aftermath of the global financial crisis, although they were also attempting to stabilize a collapsing financial system.

However, the BIS study found that falling prices don’t always or even often lead to declines in output. Indeed, they have often had the opposite effect, and helped raise output.

By contrast, the BIS economists find that asset price deflations—or falls in prices of equities or houses—do hurt economic growth. Indeed, this may be why falls in the prices of goods and services during the Great Depression appear to have done so much harm—they were happening at the same time as asset price falls, which were responsible for the damage.

“Once we control for persistent asset-price deflations and country-specific average changes in growth rates over the sample periods, persistent goods and services… deflations do not appear to be linked in a statistically significant way with slower growth even in the interwar period,” the economists write.

There is an argument that falls in the prices of goods and services are harmful when households, governments and corporations are highly indebted, because the real cost of repaying those debts rises. The BIS economists find little evidence of this link, although they are less confident about that conclusion because there is less good data available.

Again, it’s a different story for asset-price deflations.

“High debt or a period of excessive debt growth has so far not increased in a visible way the costs of goods and services price deflations,” the economists write. “Instead, it seems to have added to the strains that property price deflations in particular impose on balance sheets.”

The economists provide an illustration of why asset-price deflations are more problematic than consumer price falls. They calculate that losses on houses and equities in the wake of the 2008 crisis totalled roughly $9.1 trillion and $11.3 trillion.

“By contrast, a hypothetical deflation of, say, 1% per year over three years would imply an increase in the real value of public and private debt of roughly $1.1 trillion,” they write.

Although they don’t say it, the conclusions reached by the economists seem to underpin a familiar BIS message: its much more important to prevent asset-price booms and busts than pursue easy-monetary policies in their wake. And very easy monetary policy to combat a phantom menace may just lay the foundations for another round of boom and bust.

http://blogs.wsj.com/economics/2015/03/18/bank-of-international-settlements-questions-deflation-threat/