Should Alan Greenspan Be Worrying About Deflation?

Fortune issue: December 7, 1998


Should Alan Greenspan Be Worrying About Deflation?

First Principles

N. Gregory Mankiw

I have some important advice either for Alan Greenspan or for bond investors. The problem is, I can't decide which.

I came upon this ambiguously targeted advice by watching the market for inflation-indexed government bonds. The U.S. Treasury introduced this new type of debt in 1997 to the acclaim of most economists and the yawns of just about everyone else. (For more on inflation-indexed bonds, see FORTUNE Investor.) Today, the bonds are telling an amazing story about what the future may hold.

Consider: Ten-year indexed bonds have recently been offering a yield that is less than one percentage point below the yield on ten-year bonds without inflation protection. Taken at face value, this means that the bond market expects the consumer price index to rise by less than 1% per year. Now add the result of the 1996 Boskin commission that the CPI overstates inflation by a bit more than 1% per year, and we are left with a striking conclusion: Not only has the Fed achieved the Holy Grail of central banking--price stability--it may even have overshot. We may be on the verge of a decade of deflation.

If the bond market's forecast is right, it gives a clear mandate to Federal Reserve policymakers: Keep cutting interest rates. Usually the Fed is in the tough position of having to restrain economic growth in order to keep inflation under control. But if deflation is on the horizon, then the Fed can kill two birds---faster growth and more stable prices--with one expansionary stone.

To be honest, although a few economists on Wall Street are preaching the possibility of deflation, their colleagues greet this idea with skepticism. Most economists (including those I know at the Fed) are more worried about a resurgence of inflation. They fear that low unemployment will accelerate wage growth, which will then raise costs and be passed on in higher prices. And indeed, most private forecasts of inflation put it well above the forecast implicit in the bond market.

The problem is that the link between unemployment and inflation, while apparent in historical data, is far from precise and reliable. Standard theory says that rising inflation is a threat when unemployment falls below some threshold "natural rate." Yet the natural rate of unemployment changes over time in ways that are obvious only with hindsight, and sometimes not even then.

Several years ago many economists were estimating the natural rate between 5.5% and 6%. But unemployment has remained below that level for several years now without reigniting inflation. Economist Robert Shimer of Princeton University argues that the aging of the baby boom gets the credit: As this bulge of workers has entered middle age, they have moved into more stable jobs, pushing down the economy's natural rate of unemployment. Perhaps that's why the bond market is no longer worried about inflation, despite low unemployment.

Deflation is, I admit, a hard story to swallow. Since 1960, U.S. inflation has averaged about 4.5% per year, accumulating to an approximately fivefold increase in the price level. And by international standards, the U.S. has been a low-inflation country. Falling prices seem as hard to imagine as, say, a government budget surplus. But U.S. history does show some experience with deflation: Price declines were rapid and disruptive in the 1930s, and gradual and more benign in the late 19th century. In both cases, the average level of prices fell by over 20%. You can't rule out deflation just because you've never seen it in your lifetime.

Still don't buy it? I'm not sure I do either. But if you doubt that falling prices are about to become the norm, you should be buying indexed bonds. As long as you expect measured inflation over the next decade to be at least 1% per year, you will get a higher expected return with indexed bonds than with standard Treasuries. As a bonus, you also shield yourself against inflation uncertainty. With Alan Greenspan and his colleagues at the Fed unsure of what to do next, protecting your bond portfolio from their mistakes seems like an opportunity too good to pass up.


N. GREGORY MANKIW is an economics professor at Harvard and the author of Principles of Economics.