Deflationary Expectations Research Articles

(Dis)Solving the Zero Lower Bound Equilibrium through Income Policy

AbstractWe investigate the possibility to reflate an economy experiencing a long‐lasting zero lower bound episode with subdued or negative inflation by imposing a minimum level of wage inflation. The income policy under investigation is formalized as a downward nominal wage growth rigidity, such that wage inflation cannot be lower than a fraction of the inflation target. This policy allows dissolving the zero lower bound steady‐state equilibrium in an Overlapping Generations (OLG) model featuring “secular stagnation” and in an infinite‐life model, where this equilibrium emerges due to deflationary expectations.

'Captivated by Liquidity' – Theoretical Traps and Practical Mazes

There is no uniform theoretical standpoint on the effects of changing interest rates and the role of money among economists. Though these disputes exercise a great influence on the economic policy measures adopted as well. For the management of the 2008 global financial crisis many central banks entered into forceful interest rate cuts to contribute to the revitalisation of the economy. The economic recession caused by the pandemic of 2020 again raises the issue how central banks can stimulate growth. In this study we deal with the liquidity trap issue attributed to Keynes. Keynes pointed out that there might exist a lower interest rate limit under which money demand becomes infinite. His conceptions put the foundations to the question, at what interest rate levels might the liquidity trap – a term coined later by Robertson – phenomenon become effective. He was followed by numerous renowned economists dealing with the conception. In this paper we are discussing the most important theoretical approaches – among others the views of Hansen, Hicks, Tobin, Patinkin, Krugman, Brunner and Meltzer and Eggertson. We provide an overview on the effects of low interest rate levels adopted by Japan, by the central banks of Japan, the USA and the ECB aimed at stimulating the economy. Based on the study it can be confirmed that central banks can contribute to economic growth keeping interest rates low and therewith fostering investment. Nevertheless, beyond keeping short-term interest rates low, it might be adequate to control interest rates of other maturities and, especially under deflationary expectations, central banks should express their prolonged commitment to low interest rates.

(Dis)Solving the Zero Lower Bound Equilibrium Through Income Policy

We investigate the possibility to reflate an economy experiencing a long-lasting zero lower bound episode with subdued or negative inflation, by imposing a minimum level of wage inflation. Our proposed income policy relies on the same mechanism behind past disinflationary policies, but it works in the opposite direction. It is formalized as a downward nominal wage rigidity (DNWR) such that wage inflation cannot be lower than a fraction of the inflation target. This policy allows to dissolve the zero lower bound steady state equilibrium in an OLG model featuring “secular stagnation” and in a infinite-life model, where this equilibrium emerges due to deflationary expectations.

Monetary policy, de-anchoring of inflation expectations, and the “new normal”

Persistently low inflation rates, followed by declining inflation expectations, in advanced economies after the Great Recession have raised the question whether central banks are still able to credibly anchor inflation to their medium-term targets. The purpose of this paper is twofold. First, we investigate why agents’ expectations that over the business cycle inflation will remain in line with the target begin to falter. Our hypothesis is that agents form expectations in terms of their probabilistic belief that the economy may switch from a normal to a depression state (permanently low output and inflation), which is updated upon observing the actual state of the economy. Second, we study how the de-anchoring of expectations interacts with monetary policy to determine whether the central bank is still able to achieve its target - and hence re-anchor inflation expectations - or whether the system drifts towards depressed states. We obtain two main findings. The first is that, facing unfavourable shocks, if inflation expectations ``fall faster" than the policy rate, and the zero lower bound is reached without correcting the shock, the system converges to a new steady state - the "new normal" - with permanent negative gaps. The second is that a more aggressive monetary policy is ineffective both at the zero lower bound and above it, when the shock is large and/or when the reactivity of inflation expectations is sufficiently high. This latter finding seems to support the necessity, in those conditions, to abandon conventional monetary policy and to switch to an aggressive reflationary policy package that prevents the entrenchment of deflationary expectations.

Can inflation expectations be measured using commodity futures prices?

This paper reexamines the use of US commodity futures price data to show that the US deflation of 1929–1932 was at best no more than partially anticipated by economic actors. By focusing on the expected real interest rate, previous studies provide some empirical support for explanations of the Great Depression that are not exclusively monetary in nature. However, these studies did not consider the context and the market microstructures from which the data was sourced. Our analysis suggests that it is more likely that agricultural commodity markets adjusted to deflationary expectations by the end of 1930. Evidence from commodities futures markets, such as the Chicago Board of Trade, therefore should not be used to critique the Keynesian challenge to the classical monetarist explanation of the Great Depression.

Monetary Policy, De-Anchoring of Inflation Expectations, and the 'New Normal'

Low inflation rates in the Euro Area raise the question of whether inflation is still credibly anchored to the Euro-system’s medium term target of below, but close to 2%. The purpose of this paper is twofold. On the one hand, we investigate why agents’ inflation expectations that inflation will remain in line with the target begin to falter. On the other hand, we want to study how the de-anchoring of expectations interacts with monetary policy determining whether the central bank is still able to achieve its target - and hence re-anchor inflation expectations - or whether the system drifts away towards the liquidity trap. Two are our main findings. The first is that large unfavourable shocks might lead agents to question their trust in resilience of the system, and to revise their expectations. If inflation expectations fall faster than the policy rate, and the zero lower bound is reached without correcting the interest-rate gap, the system converges to a new steady state - the “new normal” - with permanent negative gaps. The second is that a more aggressive monetary policy is ineffective both at the ZLB and above the ZLB, when the shock is large shocks and/or when the reactivity of inflation expectations is high enough. This last finding seems to support the necessity, in those conditions, to abandon conventional monetary policy and to switch to an aggressive reflationary policy that prevents the entrenchment of deflationary expectations.

OVERVALUED: SWEDISH MONETARY POLICY IN THE 1930s

AbstractThe article discusses Sweden's monetary policy in the 1930s, which has been hailed as the first and only example of successful price‐level targeting. Our contribution is twofold. First, we argue that the crucial measure that immediately ended deflationary expectations and enabled a swift recovery was a strong and involuntary devaluation of the currency, not the adoption of a new monetary policy framework. Second, starting from the recent literature on monetary policy at the zero‐lower bound, we conclude that Sweden's exchange rate policy is more relevant for the current discussion than its tentative experience with price‐level targeting.

How Can it Work? On the Impact of Quantitavie Easing in the Eurozone

How can the quantitative easing (QE) programme launched in March 2015 by the ECB be successful in the Eurozone (EZ)? What will be its impact on the member countries? And how will it relate to countries' fiscal policies? To address these questions, we use a simple extension of the three-equation New Keynesian model. We modify the benchmark model in two respects: 1) we (re)-introduce an LM money supply and demand equation to capture the fact that the ECB operates at the zero lower bound and hence cannot use a standard Taylor rule; and 2) we extend the model to a two-country framework. The model supports the ECB official view that the channel whereby QE is meant to operate is the reversal of deflationary expectations. It also highlights that instrumental to this goal is the elimination of persistent output gaps, both at the EZ and at the country level, and hence the reduction of country-specific interest-rate spreads -- the unofficial objective of the programme. We show that QE, if large enough, can succeed for the EZ as a whole. The ECB nevertheless cannot also close individual countries' output gaps, unless specific and unrealistic conditions are met. In this case fiscal accommodation at the country level should also intervene. We show that QE can enhance the effectiveness of fiscal policy, and therefore conclude that the coordination of fiscal and monetary policies is of paramount importance.

The informational content of the embedded deflation option in TIPS

We estimate the value of the embedded option in U.S. Treasury Inflation-Protected Securities (TIPS). The embedded option value exhibits time variation that is correlated with periods of deflationary expectations. We construct embedded option explanatory variables that are statistically and economically significant for explaining future inflation, even in the presence of traditional inflation variables such as lagged inflation, the gold return, the crude oil return, the VIX return, liquidity, surveys, and the yield spread between nominal Treasuries and TIPS. After conducting robustness tests, we conclude that the TIPS embedded option contains useful information for future inflation.

Focus: Will the Politics or Economics of Deflation Prove More Harmful?

INTERNATIONAL union rights Page 3 Volume 22 Issue 2 2015 FOCUS ❐ FINANCE, AUSTERITY AND TRADE UNION RIGHTS Will the Politics or Economics of Deflation Prove More Harmful? The politics of collective action under inflation are clear, but deflation is different and it produces different political and economic pressures MARK BLYTH is Eastman Professor of Political Economy and faculty fellow at the Watson Institute for International Studies at Brown University tries this, given the aggregate effects on consumption . The same is true at the country level: all countries should not simultaneously attempt to become ‘more competitive’ if they are each other’s trading partners and exchange similar goods in a shared currency. Given this, deflationary periods produce an opposite politics than inflationary ones do. Rather than investor-friendly policies that seek to ‘bring the market back in and keep the State and labour out’, deflations, especially when they begin in already deeply depressed economies, produce broad-based cross-class debtor coalitions that directly challenge creditor interests and their supporting institutions. In such a world, we should expect existing political forces, especially those on the left, to lose vote share and be challenged by upstarts from the left and the right that seek to ‘bring the state back in and push market forces back out’, which is bad for the EMU project and all that flows from it. Seen in this way, the core creditor countries that are not deflating still operate in line with creditor politics, in which mainstream parties form coalitions to maintain the status quo, even in traditionally majoritarian states such as the UK and Sweden. The debtor countries of the periphery , those to a greater or lesser extent at risk of locking in deflationary expectations, are beginning to operate in accordance with debtor politics , which seeks to challenge the anti-inflationary , pro-creditor policies of the past 30 years. The alternative to such a political shift would be acceptance of the forced economic adjustment through unemployment and prolonged stagnation advocated by the core creditor countries. Syriza in Greece, the National Front in France, Sinn Fein in Ireland, UKIP in the UK, the SNP in Scotland, and Podemos in Spain are then more similar than different. They are all, regardless of leftist or rightist political stances, at base anti-creditor , anti-market populist movements. They constitute a threat, not just to macroeconomic stability , but to the very idea of Europe as it has been constructed over the past 30 years. When the National Front and UKIP on the right say they want out of the euro, they are not kidding. And while Syriza and Podemos say that they want to remain in the eurozone, the policies of the creditor bloc, which assert that ‘you must pay your debts even if you are insolvent’, may well push these leftist parties towards the exit, too. Given all this, what Greece represents is not an economic threat to the euro so much as a political threat. First of all, the eurozone leadership has effectively told the Greek people that more of the same policy is the only tonic available, regardless A lthough growth has returned to the periphery of Europe, with Spain, Ireland, Portugal and even Greece posting positive numbers, the rate of growth in their debts still outpaces their rate of GDP growth. That means, for example, that Portugal would have to run a current account surplus at Chinese levels for over a decade to get unemployment down to single figures, and that is simply not going to happen. Indeed, the most recent ECB unemployment projections predict double-digit unemployment out to 2017, regardless of the incipient recovery. Standard macro theory imagines that fiscal contractions are recessionary in the short run, but in the long run the supply side determines the trend rate of growth. What the eurozone has recently shown us is that you can contract so severely on the demand side that the supply side of the economy can be permanently damaged, which may have lowered inflationary expectations to a deflationary equilibrium point. This is extremely dangerous – more so for political than economic reasons. The politics of periods of inflation and deflation are radically different. Inflation is a class...

Investing in Inflation Protection

Both inflationary and deflationary concerns have emerged as global economies continue to struggle with recovery. In this confusing environment, inflation-protected bonds can play an important role in plan sponsors’ asset allocation dilemma especially in light of yesterday’s Fed announcement of Quantitative Easing (II) implementation plan. We find that IPBs have exhibited some distinct differences from other asset classes during the past decade. We highlight the following:1. IPBs as an asset-class-level inflation hedge: We find that IPBs have provided reasonable protection against inflation historically. In the US and UK, IPBs moved closely with inflation, outperforming equities and nominal bonds in inflationary periods. Nominal bonds tended to move inversely to inflation. Commodities also moved strongly with inflation but experienced greater declines when inflation fell.IPBs in a deflation scenario: Nominal bonds had stronger protection (or put optionality) on deflation relative to IPBs during the last decade. During a shift from inflationary to deflationary expectations, existing nominal bonds have benefited from having a relatively wide inflation expectation spread built into the coupon. In a prolonged deflation scenario, holders of shorter dated new issue IPBs benefit from a guaranteed redemption value, the so-called “deflation floor”, which is prevalent in IPBs issued by some countries such as the US. 2. IPBs for portfolio diversification: The correlations of IPBs with other asset classes have been relatively low for equities, commodities, and real estate, and only slightly higher than correlations of nominal bonds with those assets. IPBs exhibited relatively low correlations over the last decade with other asset classes, both from a domestic perspective and the perspective of a US international investor, supporting their attractiveness for diversification purposes.

It Takes a Regime Shift: Recent Developments in Japanese Monetary Policy through the Lens of the Great Depression

Last week, we witnessed one of the most exciting developments in monetary policymaking since the 1930s. The Japanese central bank staged an honest-to-goodness regime shift. The Bank of Japan went beyond vague promises and cheap talk. As I will describe in more detail later, it took dramatic actions and pledged convincingly to do whatever it takes to end deflation in Japan. The theoretical reasons why this regime shift may be important are well understood by economists. Persistent deflation and anemic growth suggest that Japan continues to suffer from a shortfall of demand. But their policy interest rate is already at the zero lower bound. Furthermore, riskier, long-term rates are also very low— suggesting that unconventional policies such as large-scale asset purchases are unlikely to do much to further reduce nominal rates. As discussed by Paul Krugman, Gauti Eggertsson and Michael Woodford, and others, if unconventional monetary policy can raise expected inflation, this can push down real interest rates even though nominal rates cannot fall. 1 This, in turn, can raise aggregate demand by stimulating interest

The Informational Content of the Embedded Deflation Option in TIPS

In this paper we estimate the value of the embedded option in U.S. Treasury Inflation Protected Securities (TIPS). The option value exhibits significant time variation that is correlated with periods of deflationary expectations. We use our estimated option values to construct an embedded option price index and an embedded option return index. We then use our embedded option indices as independent variables and examine their statistical and economic significance for explaining the future inflation rate. In almost all of our regressions, the embedded option return index is significant even in the presence of traditional inflation variables, such as lagged inflation, the return on gold, the return on crude oil, the VIX index return, and the yield spread between nominal Treasuries and TIPS. We conduct several robustness tests, including alternative weighting schemes, alternative variable specifications, and alternative control variables. We conclude that the embedded option in TIPS contains useful information for future inflation, both in-sample and out-of-sample. Our results should be valuable to anyone who is interested in assessing inflationary expectations.

Non-Positive Scaling Factor in Probability Quantification Methods: Deriving Consumer Inflation Perceptions and Expectations in the Whole Euro Area and Ireland

There are problems with using probability quantification methods designed for polychotomous survey questions when the scaling factor applied in those methods becomes non-positive. The way of adjusting probability methods proposed in this article and verified empirically allows using them in such circumstances. The results for the euro area and Ireland suggest that the recent financial crisis made consumer inflation perception and expectations go down; however, it did not create deflationary expectations in this group of economic agents.

The Fisher Effect under Deflationary Expectations

The response of nominal and real interest rates to expected deflation becomes problematic when nominal interest rates fall toward zero while the expected rate of deflation is increasing. As nominal interest rates approach their lower bound, further increases in expected deflation cannot cause the nominal rate to fall. Either the Fisher equation is violated or the real rate must increase. One way for the real rate to rise is for asset prices to fall. Regressions between 2003 and 2010 of the daily percentage change in the S&P 500 on the TIPS spread measuring inflation expectations show little correlation between asset prices and expected inflation from 2003 until early 2008. However, since early 2008 the correlation between changes in stock prices and in inflation expectations has been strongly positive and statistically significant.

The Informational Content of the Embedded Deflation Option in TIPS

In this paper we estimate the value of the embedded option in U.S. Treasury Inflation Protected Securities (TIPS). The option value exhibits significant time variation that is correlated with periods of deflationary expectations. We use our estimated option values to construct an embedded option price index and an embedded option return index. We then use our embedded option indices as independent variables and examine their statistical and economic significance for explaining the future inflation rate. In most of our regressions, our embedded option return index is significant even in the presence of traditional inflation variables, such as the yield spread between nominal Treasuries and TIPS, the return on gold bullion, the VIX index return, and the lagged inflation rate. We conduct several robustness tests, including alternative weighting schemes, alternative variable specifications, and alternative data samples. We conclude that the embedded option in TIPS contains useful information for future inflation, both in-sample and out-of-sample. Our results should be valuable to practitioners, monetary authorities, and policymakers alike.

Price expectations and consumption under deflation: evidence from Japanese household survey data

The Japanese economy has experienced price deflation since the mid-1990s. Despite the importance of overcoming deflation, there has been little recent research on price expectations in Japan. This paper takes advantage of an original and rich quarterly household-level data set from the “Kokumin Seikatsu Monitors” to estimate average price expectations, examine the factors that affect price expectations, and examine how changes in price expectations have affected household consumption. Our estimates indicate that average price expectations ranged from minus 0.2 to 0% in 2001 and 2002. However, there was an increase to 1% in the first quarter of 2003, followed by a decline to 0.2% in the second quarter, and a steady increase toward 0.8% by the first quarter of 2004. Price expectations depend on current price movements and lagged expectations. A series of quantitative easing monetary policies were not very effective in changing the price expectations, since the policy announcements caused revision of price expectations only for a small portion, i.e., 5–10% of people surveyed. The jump observed in the first quarter of 2003 was a reaction to the outbreak of the Iraq war. Our study also confirms that deflationary expectations discourage household consumption, mainly durable consumption, by delaying the timing of purchases, suggesting that the deflationary expectations should be upwardly revised to restore a vital Japanese economy.

POLICY MAKING IN DEFLATIONARY JAPAN*

The prolonged recession and deflation in Japan since 1990 presents novel problems to economists. The recession was certainly triggered by real factors such as the slowing down of capacity growth. At the same time, it was aggravated by the monetary contraction in the early 1990s and the inability of the monetary policy to cope with deflation, a fortiori a monetary phenomenon. With the zero-bound interest rate, traditional monetary policy is of limited effect, and unconventional monetary policy, such as inflation (or price-level) targeting, should be employed instead, in order to change the persistent deflationary expectations in the public.

Price deflation and consumption: central bank policy and Japan’s economic and financial stagnation

In this paper we review the major causes of Japan’s economic and financial stagnation during the past decade, considering in particular how past policies of the Bank of Japan have generated the current deflationary environment. This paper does not attribute Japan’s economic and financial distress entirely to Bank of Japan policy nor does it fail to recognize the shift in policy starting March 2001 when the Bank shifted toward a policy of “quantitative easing” that generated a significant increase in the growth of high powered money by late 2002. The paper argues the Bank’s deflationary policies starting in the mid-1990s up to late 2002 exacerbated the distress and it remains to be seen whether the new policy will reverse deflationary expectations. We consider the economic effects of the deflation, and in particular we argue for a link between expected deflation when nominal interest rates approach their lower bound and a decline in consumption. We find some initial evidence for this hypothesis using both a simple two-period model with a simulation and estimates of consumption functions for both the United States and Japan. Reinflation is thus a necessary, though not a sufficient condition for Japanese economic recovery.

Policy Duration Effect Under Zero Interest Rates: An Application of Wavelet Analysis

A major feature of recent monetary policy in Japan has been heavy reliance on the so-called policy duration effect. This policy employs a commitment to compensate for the central bank’s inability to lower the interest rate below zero by altering the anticipated course of monetary policy actions. This paper analyzes the behavior of the yield curve and examines the effectiveness and limitations of monetary policy commitment under zero interest rates with four indicators for policy duration effect. Specifically, we extend our previous study (Okina and Shiratsuka (2003)) by applying wavelet analysis to indicators for policy duration effect. As in the previous study, the policy duration effect was found to be highly effective in stabilizing market expectations for the path of short-term interest rates, thereby reducing longer-term interest rates and flattening the yield curve. The policy duration effect, however, failed to reverse deflationary expectations in financial markets.