Greenspan, Alan

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.