Escaping from the Deflation Trap

Deflation will be the overriding topic when America's Federal Reserve Board meets on June 24th. Michael Woodford, one of the world's leading authorities on central banking, offers a strategy to break the grip of falling prices.

Alan Greenspan's recent speech to a conference of bankers in Berlin--admitting the desirability of "insurance" against the risk of deflation in the US, even if it has not yet appeared--focused attention on a crucial issue. What can be done to stabilize an economy when nominal interest rates cannot be lowered any further, but prices still fall and the output gap--the difference between what it can produce and what it actually does produce--remains wide? What was a theoretical curiosity raised by John Maynard Keynes in the 1930's has become the fundamental issue confronting policymakers in the world's largest economies.

Japan poses the clearest example of this problem. Growth there remains anemic, and deflation lingers, suggesting a need for monetary stimulus. But the benchmark interest rate in Japan has been essentially zero for the past four years, so the standard form of monetary stimulus--reducing short_term nominal interest rates--is unavailable.

With the Fed's operating target now only 1.25% and signs of recovery in the US fragile, many now fear that the US is poised to confront a similar situation. The recent cut in the ECB's policy rate amid warnings of possible deflation in Germany lead some to fear that the euro zone may be equally at risk.