Once deflation sets in, it can take years for an economy to break out of its grip. Japan's "Lost Decade" lasted from 1991 through 2001, and even then its growth was slow. But what can central banks do to fight the pernicious and devastating effects of deflation? In recent years, central banks around the world have used extreme measures and innovative tools to combat deflation in their economies.

  • Deflation is the result of a vicious cycle that starts with a slowdown in consumer spending, followed by business cutbacks and layoffs, leading to high unemployment, less spending, and more defaults.
  • The Federal Reserve's famous quantitative easing (QE) policy following the 2008-2009 financial crisis is a model strategy for combating deflation.
  • The long-term effects, including a massive increase in public debt, are yet to be determined.


The Effects of Deflation

Deflation is defined as a sustained and broad decline in price levels in an economy over a period of time. Deflation is the opposite of inflation and is different from disinflation, which describes an economy in which the inflation rate is positive but falling.

Brief periods of lower prices, as in a disinflationary environment, are not bad for the economy or for consumers. Paying less for some goods and services leaves consumers with more money left over for discretionary expenditures, which should boost the economy.

In a period of declining inflation, the central bank is not likely to be "hawkish" (in other words, inclined to aggressively raise interest rates) on monetary policy, which would also stimulate the economy.

Deflation is different. Deflation occurs when consumers stop spending any more than necessary. As prices fall, they put off buying big-ticket items in the hope that they'll fall further. The trend continues and builds up speed.

In the United States, consumer spending accounts for 70% of the economy, and economists consider it a reliable engine of the global economy. Imagine the negative impact if American consumers put off spending on big-ticket items because they think goods may be cheaper next year.

Once consumer spending begins to decelerate, it has a ripple effect on the business sector. Companies begin to defer or slash capital expenditures—spending on property, building, equipment, new projects, and investments. They may begin downsizing their workforces to maintain profitability.

This creates a vicious circle, with corporate layoffs imperiling consumer spending, which, in turn, leads to more layoffs and rising unemployment. Such a contraction in consumer and corporate spending can trigger a recession and, in the worst-case scenario, a full-blown depression.

Another hugely negative effect of deflation is its impact on debt. While inflation chips away at the real (inflation-adjusted) value of debt, deflation adds to the real debt burden. Defaults and bankruptcies by indebted households and companies rise.

Recent Deflation Concerns

Over the past quarter-century, concerns about deflation have spiked after big financial crises such as the Asian crisis of 1997, the "tech wreck" of 2000 to 2002, and the Great Recession of 2008 to 2009. The concerns were intensified by Japan's experience after its asset bubble burst in the early 1990s.

Here's how it happened: To counter the Japanese yen's 50% rise in the 1980s and the resulting recession in 1986, Japan embarked on a program of monetary and fiscal stimulus. This caused a massive asset bubble as Japanese stocks and urban land prices tripled in the second half of the 1980s.

The bubble burst in 1990. The Nikkei index lost a third of its value within a year and kept sliding until October 2008, when the Nikkei was down 80% from its December 1989 peak. As deflation became entrenched, the Japanese economy—which had been one of the fastest-growing in the world—slowed dramatically. Real GDP growth averaged only 1.1% annually beginning in 1990.

The torrent of cash unleashed by quantitative easing paid off, at least for the stock market. Global stock market capitalization more than doubled between 2008 and 2015, to about $69 trillion,

The Great Recession

The Great Recession of 2008 to 2009 sparked fears of a similar period of prolonged deflation in the United States and elsewhere because of the catastrophic collapse in prices of a wide range of assets including stocks, mortgage-backed securities, real estate, and commodities.

The global financial system was also thrown into turmoil by the insolvency of a number of major banks and financial institutions in the United States and Europe, exemplified by the bankruptcy of Lehman Brothers in September 2008.

There were widespread concerns that scores of banks and financial institutions would fall in a domino effect leading to a collapse of the financial system, a shattering of consumer confidence, and outright deflation.

How the Federal Reserve Fought Deflation

Ben Bernanke, chairman of the Federal Reserve from 2006 to 2014, had acquired the nickname "Helicopter Ben." In a 2002 speech, he had referenced the economist Milton Friedman's famous line that deflation could be countered by dropping money from a helicopter. Friedman's point was that putting money directly into consumers' hands was a sure way to stimulate spending.

Although Bernanke did not have to resort to a helicopter drop, the Federal Reserve used some of the same methods outlined in his 2002 speech from 2008 onwards to combat the worst recession since the 1930s.

Rock-Bottom Interest Rates

In December 2008, the Federal Open Market Committee (FOMC), the Federal Reserve's monetary policy body, cut the target federal funds rate to near-zero. The fed funds rate is the Federal Reserve's conventional instrument of monetary policy, but with that rate now at the "zero lower bound"—so-called because nominal interest rates cannot go below zero—the Federal Reserve had to resort to unconventional monetary policies to ease credit conditions and stimulate the economy.

The Federal Reserve turned to two main types of unconventional monetary policy tools: (1) forward policy guidance and (2) large-scale asset purchases, better known as quantitative easing (QE).

The Federal Reserve introduced explicit forward policy guidance in the August 2011 FOMC statement to influence longer-term interest rates and financial market conditions. The Fed stated that it expected economic conditions to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

This guidance led to a drop in Treasury yields as investors grew comfortable that the Fed would delay raising rates for the next two years. The Fed subsequently extended its forward guidance twice in 2012 as a tepid recovery caused it to push the horizon for keeping rates low.

A Flood of Cash

But it was quantitative easing that made headlines and became synonymous with the Fed's easy-money policies. QE essentially involves the creation of new money by a central bank to buy securities from the nation's banks and pump liquidity into the economy in order to drive down long-term interest rates.

This ripples through to other interest rates across the economy, stimulating demand for loans from consumers and businesses. Banks can meet this higher demand for loans because of the money they got from the central bank in exchange for their security holdings.

The QE Timeline

The timeline of the Fed's QE program was as follows:

  • Between December 2008 and August 2010, the Federal Reserve purchased $1.75 trillion in bonds, comprising $1.25 trillion in mortgage-backed securities issued by government agencies like Fannie Mae and Freddie Mac, $200 billion in agency debt, and $300 billion in longer-term Treasuries. This and related initiatives became known as QE1.
  • In November 2010, the Fed announced QE2, which would involve buying another $600 billion of longer-term Treasuries at a pace of $75 billion per month.
  • In September 2012, the Fed launched QE3, initially buying mortgage-backed securities at a rate of $40 billion per month. The Fed expanded the program in January 2013 by buying $45 billion of longer-term Treasuries per month for a total monthly purchase commitment of $85 billion.
  • In December 2013, the Fed announced that it would taper off the pace of asset purchases in measured steps.

How Other Central Banks Fought Deflation

Other central banks have also resorted to unconventional monetary policies to stimulate their economies and stave off deflation.

Japan's Strategy

In December 2012, then-Japanese Prime Minister Shinzo Abe launched an ambitious policy framework to end deflation and revitalize the economy.

Called “Abenomics," the program had three main elements: monetary easing, flexible fiscal policy, and structural reforms.

In April 2013, the Bank of Japan announced a record QE program. The central bank announced that it would buy Japanese government bonds and double the monetary base to 270 trillion yen by the end of 2014 with the objective of ending deflation and achieving inflation of 2% by 2015.

The structural reforms element required measures to offset the effects of an aging population, such as allowing foreign labor and encouraging the hiring of women and older workers. 

Europe's Strategy

In January 2015, the European Central Bank (ECB) embarked on its own version of QE by pledging to buy at least 1.1 trillion euros of bonds at a monthly pace of 60 billion euros through September 2016.

The ECB launched its QE program six years after the Federal Reserve in an effort to support the fragile recovery in Europe and ward off deflation. Its unprecedented move to cut the benchmark lending rate below 0% in late-2014 had met with limited success.

While the ECB was the first major central bank to experiment with negative interest rates, a number of central banks in Europe, including those of Sweden, Denmark, and Switzerland, have pushed their benchmark interest rates below the zero bound. What will be the consequences of such unconventional measures?

Intended and Unintended Consequences

The torrent of cash in the global financial system as a result of QE programs and other unconventional measures have paid off for the stock market. Global stock market capitalization more than doubled between 2008 and 2015, to about $69 trillion.

The S&P 500 tripled over this period while many equity indices in Europe and Asia hit all-time highs.

But the impact on the real economy is less clear. As the flood of money tapered off, the pace of economic growth slowed. In the U.S., real gross domestic product (GDP) growth was 1.64% in 2016, 2.37% in 2017, 2.93 in 2018, and 2.16% in 2019.

Meanwhile, the concerted moves to fend deflation globally have had some strange consequences: 

  • Central bank balance sheets are bloating: Large-scale asset purchases by the Federal Reserve, the Bank of Japan, and the ECB are swelling up their balance sheets to record levels. The Fed's balance sheet has grown from less than $870 billion in August 2007 to about $7.4 trillion at the end of 2020. Shrinking these central bank balance sheets may have negative consequences down the road.
  • QE could lead to a covert currency war: QE programs have led to major currencies plunging across the board against the U.S. dollar. With most nations having exhausted almost all their options to stimulate growth, currency depreciation may be the only tool remaining to boost economic growth, which could lead to a covert currency war.
  • European bond yields have turned negative: More than a quarter of government debt issued by European governments currently has negative yields. This may be a result of the ECB's bond-buying program, but it could also be signaling a sharp economic slowdown in the future.

The Bottom Line

The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war. An unspoken fear is that central banks may have expended most, if not of all of their ammunition in beating back deflation. If this is the case in the years ahead, deflation could be far more difficult to vanquish.