Allowing for known measurement biases, these inflation indexes have been in a neighborhood that corresponds to effective price stability--a long-held goal assigned to the Federal Reserve by the Congress. But we can pause at this achievement only for a moment, mindful that we face new challenges in maintaining price stability, specifically to prevent inflation from falling too low. This is one reason the FOMC has adopted a quite accommodative stance of policy. A very low inflation rate increases the risk that an adverse shock to the economy would be more difficult to counter effectively. Indeed, there is an especially pernicious, albeit remote, scenario in which inflation turns negative against a backdrop of weak aggregate demand, engendering a corrosive deflationary spiral.

We need a much wider fire break, in logging and forestry terms, because we know so little about [deflation]. So we lean over backwards to make certain that we contain deflationary forces.

Although the U.S. economy has largely escaped any deflation since World War II, there are some well-founded reasons to presume that deflation is more of a threat to economic growth than is inflation. For one, the lower bound on nominal interest rates at zero threatens ever-rising real rates if deflation intensifies. A related consequence is that even if debtors are able to refinance loans at zero nominal interest rates, they may still face high and rising real rates that cause their balance sheets to deteriorate.

Another concern about deflation resides in labor markets. Some studies have suggested that nominal wages do not easily adjust downward. If lower price inflation is accompanied by lower average wage inflation, then the prevalence of nominal wages being constrained from falling could increase as price inflation moves toward or below zero. In these circumstances, the effective clearing of labor markets would be inhibited, with the consequence being higher rates of unemployment.

Taken together, these considerations suggest that deflation could well be more damaging than inflation to economic growth. While this asymmetry should not be overlooked, several factors limit its significance. In particular, more rapid advances in productivity can make this asymmetry less severe. Fast growth of productivity, by buoying expectations of future advances of wages and earnings and thus aggregate demand, enables real interest rates to be higher than would otherwise be the case without restricting economic growth. Moreover, to the extent that more-rapid growth of productivity shows through to faster gains in nominal wages, there will be fewer instances in which nominal wages will be pressured to fall.

One also should not overstate the difficulties posed for monetary policy by the zero bound on interest rates and nominal wage inflexibility even in the absence of faster productivity growth. The expansion of the monetary base can proceed even if overnight rates are driven to their zero lower bound. The Federal Reserve has authority to purchase Treasury securities of any maturity and indeed already purchases such securities as part of its procedures to keep the overnight rate at its desired level. This authority could be used to lower interest rates at longer maturities. Such actions have precedent: Between 1942 and 1951, the Federal Reserve put a ceiling on longer-term Treasury yields at 2-1/2 percent. With respect to potential difficulties in labor markets, results from research remain ambiguous on the extent and persistence of downward rigidity in nominal compensation.

Clearly, it would be desirable to avoid deflation. But if deflation were to develop, options for an aggressive monetary policy response are available.

I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself...The second bulwark...is the Federal Reserve System itself.

The Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero. Most central banks seem to understand the need for a buffer zone.

When inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.  By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails.

So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself...The second bulwark against deflation in the United States...is the Federal Reserve System itself...I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief...Having said that deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether.

There is nothing inherent in our objective for price stability and what we are trying to do about the purchasing power of money that says that when we have a favorable supply shock we should raise our money growth objectives. There’s no more reason to do that than to cut the money growth targets if we had an adverse supply shock.  We wouldn’t do that. I’m sure that back in the 1970s or the 1980s we didn’t argue for lowering our targets. What we want to do is to view the transitory effects of the acceleration in productivity growth in a lower reported rate of inflation or transitory decline in the price level as an increase in the purchasing power of money. It would be a one-time decline in the price level--I don’t want to use that “D” word. And then when the supply shock goes away, we would return toward the sort of balanced equilibrium that we would have been in.

As we move closer to price stability, the necessity of measuring prices accurately has become an especial challenge. Biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, a debate has emerged over whether our economies are moving toward price deflation...

In thinking about the problems of price measurement, a distinction must be made between the measurement of individual prices, on the one hand, and the aggregation of those prices into indexes of the overall price level, on the other. The notion of what we mean by a general price level--or more relevantly, its change--is never unambiguously defined. ...

It is the measurement of individual prices, not the aggregation of those prices, that is so difficult conceptually. At first glance, observing and measuring prices might not appear especially daunting. After all, prices are at the center of virtually all economic transactions. But, in fact, the problem is extraordinarily complex. To be sure, the nominal value--in dollars or deutsche marks, for example--of most transactions is unambiguously exact and, at least in principle, is amenable to highly accurate estimation by our statistical agencies. ...

But when the characteristics of products and services are changing rapidly, defining the unit of output, and thereby adjusting an item's price for improvements in quality, can be exceptionally difficult. These problems are becoming pervasive in modern economies as service prices, which are generally more difficult to measure, become more prominent in aggregate price measures. One does not have to look to the most advanced technology to recognize the difficulties that are faced. To take just a few examples, automobile tires, refrigerators, winter jackets, and tennis rackets have all changed in ways that make them surprisingly hard to compare to their counterparts of twenty or thirty years ago.