Caused a volcanic winter that dropped temperatures by 0.4–0.7°C (or 0.7–1°F) worldwide
The year 1816 AD is known as the Year Without a Summer because of severe climate abnormalities that caused average global temperatures to decrease by 0.4–0.7 °C (0.7–1 °F). Summer temperatures in Europe were the coldest of any on record between 1766 and 2000, resulting in crop failures and major food shortages across the Northern Hemisphere.
Evidence suggests that the anomaly was predominantly a volcanic winter event caused by the massive 1815 eruption of Mount Tambora in April in the Dutch East Indies (modern-day Indonesia). This eruption was the largest in at least 1,300 years (after the hypothesized eruption causing the volcanic winter of 536); its effect on the climate may have been exacerbated by the 1814 eruption of Mayon in the Philippines.
Description
The Year Without a Summer was an agricultural disaster; historian John D. Post called it "the last great subsistence crisis in the Western world". The climatic aberrations of 1816 had their greatest effect on New England, Atlantic Canada, and Western Europe.
These eruptions had built up a substantial amount of atmospheric
dust, and thus temperatures fell worldwide as the airborne material
blocked sunlight in the stratosphere. According to a 2012 analysis by Berkeley Earth,
the 1815 Tambora eruption caused a temporary drop in the Earth's
average land temperature of about one degree Celsius; smaller
temperature drops were recorded from the 1812–1814 eruptions.
The Earth had already been in a centuries-long period of cooling that began in the 14th century. Known today as the Little Ice Age,
it had already caused considerable agricultural distress in Europe. The
eruption of Tambora occurred near the end of the Little Ice Age,
exacerbating the background global cooling of the period.
This period also occurred during the Dalton Minimum, a period of relatively low solar activity from 1790 to 1830. May 1816 had the lowest Wolf number
(0.1) to date since records on solar activity began. It is not yet
known, however, if and how changes in solar activity affect Earth's
climate, and this correlation does not prove that lower solar activity
produces global cooling.
Africa
No direct evidence for conditions in the Sahel
region have been found, though conditions from surrounding areas have
implied above-normal rainfall. Below the Sahel, the coastal regions of
West Africa likely experienced below-normal levels of precipitation.
Severe storms affected the South African coast during the Southern
Hemisphere winter. On July 29–30, 1816, a violent storm occurred near Cape Town, which brought forceful northerly winds and hail and caused severe damage to shipping.
Asia
The monsoon season in China was disrupted, resulting in overwhelming floods in the Yangtze Valley. Fort Shuangcheng reported fields disrupted by frost and conscripts deserting as a result. Summer snowfall or otherwise mixed precipitation was reported in various locations in Jiangxi and Anhui. In Taiwan, snow was reported in Hsinchu and Miaoli, and frost was reported in Changhua. A large-scale famine in Yunnan helped reverse the fortunes of the ruling Qing dynasty.
In India, the delayed summer monsoon caused late torrential rains that aggravated the spread of cholera from a region near the Ganges in Bengal to as far as Moscow. In Bengal, abnormal cold and snow was reported in the winter monsoon.
In Japan, which was still cautious after the cold-weather-related Great Tenmei famine of 1782–1788, cold damaged crops, but no crop failures were reported and there was no adverse effect on population.
As a
result of the series of volcanic eruptions in the 1810s, crops had been
poor for several years; the final blow came in 1815 with the eruption of
Tambora. Europe, still recuperating from the Napoleonic Wars, suffered from widespread food shortages, resulting in its worst famine of the century. Low temperatures and heavy rains resulted in failed harvests in Great Britain and Ireland. Famine was prevalent in north and southwest Ireland, following the failure of wheat, oat, and potato harvests. Food prices rose sharply throughout Europe. With the cause of the problems unknown, hungry people demonstrated in front of grain markets and bakeries. Food riots
took place in many European cities. Though riots were common during
times of hunger, the food riots of 1816 and 1817 were the most violent
period on the continent since the French Revolution.
Between 1816 and 1819, major typhus
epidemics occurred in parts of Europe, including Ireland, Italy,
Switzerland, and Scotland, precipitated by the famine. More than 65,000
people died as the disease spread out of Ireland.
The long-running Central England temperature
record reported the eleventh coldest year on record since 1659, as well
as the third coldest summer and the coldest July on record.
Widespread flooding of Europe's major rivers is attributed to the
event, as is frost in August. Hungary experienced snowfall colored brown
by volcanic ash; in northern Italy, red snow fell throughout the year.
In western Switzerland, the summers of 1816 and 1817 were so cold that an ice dam formed below a tongue of the Giétro Glacier in the Val de Bagnes, creating a lake. Despite engineer Ignaz Venetz's
efforts to drain the growing lake, the ice dam collapsed
catastrophically in June 1818, killing forty people in the resulting
flood.
North America
In
the spring and summer of 1816, a persistent "dry fog" was observed in
parts of the eastern United States. The fog reddened and dimmed sunlight
such that sunspots
were visible to the naked eye. Neither wind nor rainfall dispersed the
"fog", retrospectively characterized by Clive Oppenheimer as a
"stratospheric sulfateaerosol veil".
The weather was not in itself a hardship for those accustomed to
long winters. Hardship came from the weather's effect on crops and thus
on the supply of food and firewood. The consequences were felt most
strongly at higher elevations, where farming was already difficult even
in good years. In May 1816, frost killed off most crops in the higher elevations of Massachusetts, New Hampshire, Vermont, and upstate New York. On June 6, snow fell in Albany, New York, and Dennysville, Maine. In Cape May, New Jersey, frost was reported five nights in a row in late June, causing extensive crop damage.
Though fruit and vegetable crops survived in New England, corn was
reported to have ripened so poorly that no more than a quarter of it was
usable for food, and much of it was moldy and not even fit for animal
feed.
The crop failures in New England, Canada, and parts of Europe caused
food prices to rise sharply. In Canada, Quebec ran out of bread and
milk, and Nova Scotians found themselves boiling foraged herbs for
sustenance.
Sarah Snell Bryant, of Cummington, Massachusetts, wrote in her diary: "Weather backward." At the Church Family of Shakers near New Lebanon, New York,
Nicholas Bennet wrote in May 1816 that "all was froze" and the hills
were "barren like winter". Temperatures fell below freezing almost every
day in May. The ground froze on June 9; on June 12, the Shakers had to
replant crops destroyed by the cold. On July 7, it was so cold that all
of their crops had stopped growing. Salem, Massachusetts physician
Edward Holyoke - a weather observer and amateur astronomer - while in
Franconia, New Hampshire, wrote on June 7, "exceedingly cold. Ground
frozen hard, and squalls of snow through the day. Icicles 12 inches long
in the shade of noon day." After a lull, by August 17, Holyoke noted an
abrupt change from summer to winter by August 21, when a meager bean
and corn crop were killed. "The fields," he wrote, "were as empty and
white as October." The Berkshires saw frost again on August 23, as did much of New England and upstate New York.
Massachusetts historian William G. Atkins summed up the disaster:
Severe frosts occurred every month; June 7th and 8th snow
fell, and it was so cold that crops were cut down, even freezing the
roots ... In the early Autumn when corn was in the milk [the endosperm inside the kernel was still liquid]
it was so thoroughly frozen that it never ripened and was scarcely
worth harvesting. Breadstuffs were scarce and prices high and the poorer
class of people were often in straits for want of food. It must be
remembered that the granaries of the great west had not then been opened
to us by railroad communication, and people were obliged to rely upon
their own resources or upon others in their immediate locality.
In July and August, lake and river ice was observed as far south as northwestern Pennsylvania. Frost was reported in Virginia on August 20 and 21.
Rapid, dramatic temperature swings were common, with temperatures
sometimes reverting from normal or above-normal summer temperatures as
high as 95 °F (35 °C) to near-freezing within hours. Thomas Jefferson, by then retired from politics to his estate at Monticello,
sustained crop failures that sent him further into debt. On September
13, a Virginia newspaper reported that corn crops would be one half to
two-thirds short and lamented that "the cold as well as the drought has
nipt the buds of hope". A Norfolk, Virginia, newspaper reported:
It is now the middle of July, and we have not yet had
what could properly be called summer. Easterly winds have prevailed for
nearly three months past ... the sun during that time has generally been
obscured and the sky overcast with clouds; the air has been damp and
uncomfortable, and frequently so chilling as to render the fireside a
desirable retreat.
Regional farmers succeeded in bringing some crops to maturity, but corn and other grain prices rose dramatically. The price of oats, for example, rose from 12¢ per bushel
in 1815 to 92¢ per bushel in 1816. Crop failures were aggravated by
inadequate transportation infrastructure; with few roads or navigable
inland waterways and no railroads, it was prohibitively expensive to
import food in most of the country.
Maryland experienced brown, bluish, and yellow snowfall in April and May, colored by volcanic ash in the atmosphere.
South America
A newspaper account of northeastern Brazil was published in the United Kingdom:
By an arrival at Liverpool we have received accounts from Pernambuco
of the 8th of Feb. [1817], which state that a most uncommon drought has
been experienced in the tropical regions of the Brazils, or that part
of the country between Pernambuco and Rio Janiero.
By this circumstance all the streams had been dried up, the cattle were
dying or dead, and all the population emigrating to the borders of the
great rivers in search of water. The greatest distress prevailed,
provisions were wanting, and the mills completely at a stand. They have
no windmills, so that no corn could be ground. Vessels have been sent
from Pernambuco to the United States to fetch flour, and what had tended
to increase this distress was the interruption of the coasting trade
through the dread of war with Buenos Ayres.
High levels of tephra
in the atmosphere caused a haze to hang over the sky for several years
after the eruption, and created rich red hues in sunsets. Paintings
during the years before and after seem to confirm that these striking
reds were not present before Mount Tambora's eruption, and depict moodier, darker scenes, even in the light of both the sun and the moon. Caspar David Friedrich's The Monk by the Sea (ca. 1808–1810) and Two Men by the Sea (1817) indicate this shift of mood.
A 2007 study analyzing paintings created between the years 1500 and
1900 around the times of notable volcanic events found a correlation
between volcanic activity and the amount of red used in the painting. High levels of tephra in the atmosphere led to spectacular sunsets during this period, as depicted in the paintings of J. M. W. Turner, and may have given rise to the yellow tinge predominant in his paintings such as Chichester Canal (1828). Similar phenomena were observed after the 1883 eruption of Krakatoa, and on the West Coast of the United States following the 1991 eruption of Mount Pinatubo.
The lack of oats to feed horses may have inspired the German inventor Karl Drais to research new ways of horseless transportation, which led to the invention of the draisine and velocipede, a precursor of the bicycle.
The crop failures of the "Year without a Summer" may have shaped the settlement of the Midwestern United States, as many thousands of people left New England for western New York and the Northwest Territory in search of a more hospitable climate, richer soil, and better growing conditions. Indiana became a state in December 1816, and Illinois did two years later. British historian Lawrence Goldman has suggested that migration into the burned-over district of upstate New York was responsible for centering the abolitionist movement in that region.
According to historian L. D. Stillwell, Vermont
alone experienced a decrease in population of between 10,000 and 15,000
in 1816 and 1817, erasing seven previous years of population growth. Among those who left Vermont were the family of Joseph Smith, who moved from Norwich, Vermont, to Palmyra, New York. This move precipitated the series of events that culminated in Smith founding the Church of Jesus Christ of Latter-day Saints.
In June 1816, "incessant rainfall" during the "wet, ungenial summer" forced Mary Shelley, Percy Bysshe Shelley, Lord Byron, John William Polidori, and their friends to stay indoors at Villa Diodati for much of their Swiss holiday. Inspired by a collection of German ghost stories that they had read, Lord Byron proposed a contest to see who could write the scariest story, leading Shelley to write Frankenstein and Lord Byron to write "A Fragment", which Polidori later used as inspiration for The Vampyre – a precursor to Dracula. These days inside Villa Diodati, remembered fondly by Mary Shelley, were occupied by opium use and intellectual conversations.
After listening intently to one of these conversations, she awoke with
the image of Victor Frankenstein kneeling over his monstrous creation,
and thus was inspired to write Frankenstein. Lord Byron was inspired to write the poem "Darkness" by a single day when "the fowls all went to roost at noon and candles had to be lit as at midnight". The imagery in the poem is starkly similar to the conditions of the Year Without a Summer:
I had a dream, which was not all a dream.
The bright sun was extinguish'd, and the stars
Did wander darkling in the eternal space,
Rayless, and pathless, and the icy earth
Swung blind and blackening in the moonless air;
Morn came and went—and came, and brought no day
Justus von Liebig, a chemist who had experienced the famine as a child in Darmstadt, later studied plant nutrition and introduced mineral fertilizers.
The Hatepe eruption (sometimes referred to as the Taupō eruption), around AD 180
The winter of 536 has been linked to the effects of a volcanic eruption, possibly at Krakatoa, or of Ilopango in El Salvador
The Heaven Lake eruption of Paektu Mountain between modern-day North Korea and the People's Republic of China, in 969 (± 20 years), is thought to have had a role in the downfall of Balhae
An eruption of Huaynaputina, in Peru, caused 1601 to be the coldest year in the Northern Hemisphere for six centuries (see Russian famine of 1601–1603); 1601 consisted of a bitterly cold winter, a cold, frosty, nonexistent spring, and a cool, cloudy, wet summer
An eruption of Laki, in Iceland,
was responsible for up to hundreds of thousands of fatalities
throughout the Northern Hemisphere (over 25,000 in England alone), and
one of the coldest winters ever recorded in North America, 1783–1784;
long-term consequences included poverty and famine that may have
contributed to the French Revolution in 1789.
The 1883 eruption of Krakatoa
caused average Northern Hemisphere summer temperatures to fall by as
much as 1.2 °C (2.2 °F). One of the wettest rainy seasons in recorded
history followed in California during 1883–1884.
The eruption of Mount Pinatubo in 1991 led to odd weather patterns and temporary cooling in the United States, particularly in the Midwest
and parts of the Northeast. Every month in 1992 except for January and
February was colder than normal. More rain than normal fell across the
West Coast of the United States, particularly California, during the
1991–1992 and 1992–1993 rainy seasons. The American Midwest experienced
more rain and major flooding during the spring and summer of 1993. This
may also have contributed to the historic "Storm of the Century" on the Atlantic Coast in March that same year.
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency
over time, but deflation increases it. This allows more goods and
services to be bought than before with the same amount of currency.
Deflation is distinct from disinflation, a slowdown in the inflation rate; i.e., when inflation declines to a lower rate but is still positive.
Economists generally believe that a sudden deflationary shock is a problem in a modern economy because it increases the real value of debt, especially if the deflation is unexpected. Deflation may also aggravate recessions and lead to a deflationary spiral (see later section).
Some economists argue that prolonged deflationary periods are
related to the underlying of technological progress in an economy,
because as productivity increases (TFP), the cost of goods decreases.
In the IS–LM model (investment and saving equilibrium – liquidity preference and money supply equilibrium model), deflation is caused by a shift in the supply and demand curve for goods and services. This in turn can be caused by an increase in supply, a fall in demand, or both.
When prices are falling, consumers have an incentive to delay
purchases and consumption until prices fall further, which in turn
reduces overall economic activity. When purchases are delayed,
productive capacity is idled and investment falls, leading to further
reductions in aggregate demand. This is the deflationary spiral. The way to reverse this quickly would be to introduce an economic stimulus. The government could increase productive spending on things like infrastructure or the central bank could start expanding the money supply.
Deflation is also related to risk aversion, where investors and buyers will start hoarding money because its value is now increasing over time. This can produce a liquidity trap
or it may lead to shortages that entice investments yielding more jobs
and commodity production. A central bank cannot, normally, charge
negative interest for money, and even charging zero interest often
produces less stimulative effect than slightly higher rates of interest.
In a closed economy,
this is because charging zero interest also means having zero return on
government securities, or even negative return on short maturities. In
an open economy it creates a carry
trade, and devalues the currency. A devalued currency produces higher
prices for imports without necessarily stimulating exports to a like
degree.
Deflation is the natural condition of economies when the supply
of money is fixed, or does not grow as quickly as population and the
economy. When this happens, the available amount of hard currency per
person falls, in effect making money more scarce, and consequently, the purchasing power of each unit of currency increases. Deflation also occurs when improvements in production efficiency lower the overall price of goods. Competition
in the marketplace often prompts those producers to apply at least some
portion of these cost savings into reducing the asking price for their
goods. When this happens, consumers pay less for those goods, and
consequently, deflation has occurred, since purchasing power has
increased.
Rising productivity
and reduced transportation cost created structural deflation during the
accelerated productivity era from 1870 to 1900, but there was mild
inflation for about a decade before the establishment of the Federal Reserve in 1913. There was inflation during World War I, but deflation returned again after the war and during the 1930s depression. Most nations abandoned the gold standard in the 1930s so that there is less reason to expect deflation, aside from the collapse of speculative asset classes, under a fiat monetary system with low productivity growth.
In mainstream economics,
deflation may be caused by a combination of the supply and demand for
goods and the supply and demand for money, specifically the supply of
money going down and the supply of goods going up. Historic episodes of
deflation have often been associated with the supply of goods going up
(due to increased productivity) without an increase in the supply of
money, or (as with the Great Depression
and possibly Japan in the early 1990s) the demand for goods going down
combined with a decrease in the money supply. Studies of the Great
Depression by Ben Bernanke
have indicated that, in response to decreased demand, the Federal
Reserve of the time decreased the money supply, hence contributing to
deflation.
Causes include, on the demand side:
Growth deflation
Hoarding
And on the supply side:
Bank credit deflation
Debt deflation
Decision on the money supply side
Credit deflation
Growth deflation
Growth
deflation is an enduring decrease in the real cost of goods and
services as the result of technological progress, accompanied by
competitive price cuts, resulting in an increase in aggregate demand.
A structural deflation existed from the 1870s until the cycle
upswing that started in 1895. The deflation was caused by the decrease
in the production and distribution costs of goods. It resulted in
competitive price cuts when markets were oversupplied. The mild
inflation after 1895 was attributed to the increase in gold supply that
had been occurring for decades.
There was a sharp rise in prices during World War I, but deflation
returned at the war's end. By contrast, under a fiat monetary system,
there was high productivity growth from the end of World War II until the 1960s, but no deflation.
Historically not all episodes of deflation correspond with periods of poor economic growth.
Productivity and deflation are discussed in a 1940 study by the Brookings Institution
that gives productivity by major US industries from 1919 to 1939, along
with real and nominal wages. Persistent deflation was clearly
understood as being the result of the enormous gains in productivity of
the period. By the late 1920s, most goods were over supplied, which contributed to high unemployment during the Great Depression.
Bank credit deflation
Bank
credit deflation is a decrease in the bank credit supply due to bank
failures or increased perceived risk of defaults by private entities or a
contraction of the money supply by the central bank.
Debt deflation is a complicated phenomenon associated with the end of long-term credit cycles. It was proposed as a theory by Irving Fisher (1933) to explain the deflation of the Great Depression.
Money supply-side deflation
From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money or the amount of money supply per person.
A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is a nearly equal percentage increase in money velocity. This is to be expected because monetary base (MB), velocity of base money (VB), price level (P) and real output (Y) are related by definition: MBVB = PY. However, the monetary base is a much narrower definition of money than M2 money supply.
Additionally, the velocity of the monetary base is interest-rate
sensitive, the highest velocity being at the highest interest rates.
In the early history of the United States, there was no national currency and an insufficient supply of coinage.
Banknotes were the majority of the money in circulation. During
financial crises, many banks failed and their notes became worthless.
Also, banknotes were discounted relative to gold and silver, the
discount depended on the financial strength of the bank.
In recent years changes in the money supply have historically
taken a long time to show up in the price level, with a rule of thumb
lag of at least 18 months. More recently Alan Greenspan cited the time
lag as taking between 12 and 13 quarters. Bonds, equities and commodities have been suggested as reservoirs for buffering changes in the money supply.
Credit deflation
In modern credit-based economies, deflation may be caused by the central bank initiating higher interest rates (i.e., to "control" inflation), thereby possibly popping an asset bubble.
In a credit-based economy, a slow-down or fall in lending leads to less
money in circulation, with a further sharp fall in money supply as
confidence reduces and velocity weakens, with a consequent sharp
fall-off in demand for employment or goods. The fall in demand causes a
fall in prices as a supply glut
develops. This becomes a deflationary spiral when prices fall below the
costs of financing production, or repaying debt levels incurred at the
prior price level. Businesses, unable to make enough profit no matter
how low they set prices, are then liquidated. Banks get assets that have
fallen dramatically in value since their mortgage loan was made, and if
they sell those assets, they further glut supply, which only
exacerbates the situation. To slow or halt the deflationary spiral,
banks will often withhold collecting on non-performing loans (as in Japan,
and most recently America and Spain). This is often no more than a
stop-gap measure, because they must then restrict credit, since they do
not have money to lend, which further reduces demand, and so on.
Historical examples of credit deflation
In
the early economic history of the United States, cycles of inflation
and deflation correlated with capital flows between regions, with money
being loaned from the financial center in the Northeast to the commodity
producing regions of the (mid)-West and South. In a procyclical
manner, prices of commodities rose when capital was flowing in, that
is, when banks were willing to lend, and fell in the depression years of
1818 and 1839 when banks called in loans.
Also, there was no national paper currency at the time and there was a
scarcity of coins. Most money circulated as banknotes, which typically
sold at a discount according to distance from the issuing bank and the
bank's perceived financial strength.
When banks failed their notes were redeemed for bank reserves, which often did not result in payment at par value, and sometimes the notes became worthless. Notes of weak surviving banks traded at steep discounts.
During the Great Depression, people who owed money to a bank whose
deposits had been frozen would sometimes buy bank books (deposits of
other people at the bank) at a discount and use them to pay off their
debt at par value.
Deflation occurred periodically in the U.S. during the 19th
century (the most important exception was during the Civil War). This
deflation was at times caused by technological progress that created
significant economic growth, but at other times it was triggered by financial crises – notably the Panic of 1837 which caused deflation through 1844, and the Panic of 1873 which triggered the Long Depression that lasted until 1879. These deflationary periods preceded the establishment of the U.S. Federal Reserve System
and its active management of monetary matters. Episodes of deflation
have been rare and brief since the Federal Reserve was created (a
notable exception being the Great Depression) while U.S. economic progress has been unprecedented.
A financial crisis in England in 1818 caused banks to call in loans and curtail new lending, draining specie out of the U.S.
The Bank of the United States also reduced its lending. Prices for
cotton and tobacco fell. The price of agricultural commodities also was
pressured by a return of normal harvests following 1816, the year without a summer, that caused large scale famine and high agricultural prices.
There were several causes of the deflation of the severe
depression of 1839–1843, which included an oversupply of agricultural
commodities (importantly cotton) as new cropland came into production
following large federal land sales a few years earlier, banks requiring
payment in gold or silver, the failure of several banks, default by
several states on their bonds and British banks cutting back on specie
flow to the U.S.
This cycle has been traced out on a broad scale during the Great Depression. Partly because of overcapacity and market saturation and partly as a result of the Smoot–Hawley Tariff Act,
international trade contracted sharply, severely reducing demand for
goods, thereby idling a great deal of capacity, and setting off a string
of bank failures.
A similar situation in Japan, beginning with the stock and real estate
market collapse in the early 1990s, was arrested by the Japanese
government preventing the collapse of most banks and taking over direct
control of several in the worst condition.
Scarcity of official money
The United States had no national paper money until 1862 (greenbacks
used to fund the Civil War), but these notes were discounted to gold
until 1877. There was also a shortage of U.S. minted coins. Foreign
coins, such as Mexican silver, were commonly used.
At times banknotes were as much as 80% of currency in circulation
before the Civil War. In the financial crises of 1818–19 and 1837–1841,
many banks failed, leaving their money to be redeemed below par value from reserves. Sometimes the notes became worthless, and the notes of weak surviving banks were heavily discounted.
The Jackson administration opened branch mints, which over time
increased the supply of coins. Following the 1848 finding of gold in the
Sierra Nevada,
enough gold came to market to devalue gold relative to silver. To
equalize the value of the two metals in coinage, the US mint slightly
reduced the silver content of new coinage in 1853.
When structural deflation appeared in the years following 1870, a
common explanation given by various government inquiry committees was a
scarcity of gold and silver, although they usually mentioned the
changes in industry and trade we now call productivity. However, David A. Wells
(1890) notes that the U.S. money supply during the period 1879-1889
actually rose 60%, the increase being in gold and silver, which rose
against the percentage of national bank and legal tender notes.
Furthermore, Wells argued that the deflation only lowered the cost of
goods that benefited from recent improved methods of manufacturing and
transportation. Goods produced by craftsmen did not decrease in price,
nor did many services, and the cost of labor actually increased. Also,
deflation did not occur in countries that did not have modern
manufacturing, transportation and communications.
By the end of the 19th century, deflation ended and turned to mild inflation. William Stanley Jevons predicted rising gold supply would cause inflation decades before it actually did. Irving Fisher blamed the worldwide inflation of the pre-WWI years on rising gold supply.
In economies with an unstable currency, barter and other alternate currency arrangements such as dollarization
are common, and therefore when the 'official' money becomes scarce (or
unusually unreliable), commerce can still continue (e.g., most recently
in Zimbabwe).
Since in such economies the central government is often unable, even if
it were willing, to adequately control the internal economy, there is
no pressing need for individuals to acquire official currency except to
pay for imported goods.
Currency pegs and monetary unions
If a country pegs its currency to one of another country that features a higher productivity growth or a more favourable unit cost development, it must – to maintain its competitiveness – either become equally more productive or lower its factor prices (e.g., wages). Cutting factor prices fosters deflation. Monetary unions have a similar effect to currency pegs.
Effects
On spending and borrowing
Some
believe that, in the absence of large amounts of debt, deflation would
be a welcome effect because the lowering of prices increases purchasing power.
However, while an increase in the purchasing power of one's money
benefits some, it amplifies the sting of debt for others: after a period
of deflation, the payments to service a debt represent a larger amount
of purchasing power than they did when the debt was first incurred.
Consequently, deflation can be thought of as an effective increase in a
loan's interest rate. If, as during the Great Depression
in the United States, deflation averages 10% per year, even an
interest-free loan is unattractive as it must be repaid with money worth
10% more each year.
Under normal conditions, most central banks, such as the Federal
Reserve, implement policy by setting a target for a short-term interest
rate – the overnight federal funds rate
in the U.S. – and enforcing that target by buying and selling
securities in open capital markets. When the short-term interest rate
hits zero, the central bank can no longer ease policy by lowering its
usual interest-rate target. With interest rates near zero, debt relief becomes an increasingly important tool in managing deflation.
In recent times, as loan terms have grown in length and loan
financing (or leveraging) is common among many types of investments, the
costs of deflation to borrowers has grown larger.
On savings and investments
Deflation
can discourage private investment, because there is reduced
expectations on future profits when future prices are lower.
Consequently, with reduced private investments, spiraling deflation can cause a collapse in aggregate demand.
Without the "hidden risk of inflation", it may become more prudent for
institutions to hold on to money, and not to spend or invest it (burying
money). They are therefore rewarded by saving and holding money. This "hoarding" behavior is seen as undesirable by most economists. Friedrich Hayek, a libertarianAustrian-school economist, wrote that:
It is agreed that hoarding money,
whether in cash or in idle balances, is deflationary in its effects. No
one thinks that deflation is in itself desirable.
— Hayek (1932)
Compared with inflation
Deflation
causes a transfer of wealth from borrowers and holders of illiquid
assets to the benefit of savers and of holders of liquid assets and
currency, and because confused price signals cause malinvestment
in the form of underinvestment. In this sense, its effects are the
opposite of inflation, the effect of which is to transfer wealth from
currency holders and lenders (savers) and to borrowers, including
governments, and cause overinvestment. Whereas inflation encourages
short term consumption and can similarly overstimulate investment in
projects that may not be worthwhile in real terms (for example, the dot-com and housing bubbles),
deflation reduces investment even when there is a real-world demand not
being met. In modern economies, deflation is usually associated with
economic depression, as occurred in the Great Depression and the Long Depression. Deflation was present during most economic depressions in US history.
Deflationary spiral
A deflationary spiral
is a situation where decreases in the price level lead to lower
production, which in turn leads to lower wages and demand, which leads
to further decreases in the price level. Since reductions in general price level are called deflation, a deflationary spiral occurs when reductions in price lead to a vicious circle, where a problem exacerbates its own cause. In science, this effect is also known as a positive feedback loop. Another economic example of this situation in economics is the bank run.
During
severe deflation, targeting an interest rate (the usual method of
determining how much currency to create) may be ineffective, because
even lowering the short-term interest rate to zero may result in a real
interest rate which is too high to attract credit-worthy borrowers. In
the 21st-century, negative interest rates have been tried, but it cannot
be too negative, since people might withdraw cash from bank accounts if
they have a negative interest rate. Thus the central bank must directly
set a target for the quantity of money (called "quantitative easing")
and may use extraordinary methods to increase the supply of money, e.g.
purchasing financial assets of a type not usually used by the central
bank as reserves (such as mortgage-backed securities). Before he was Chairman of the United States Federal Reserve, Ben Bernanke claimed in 2002, "sufficient injections of money will ultimately always reverse a deflation", although Japan's deflationary spiral was not broken by the amount of quantitative easing provided by the Bank of Japan.
Until the 1930s, it was commonly believed by economists
that deflation would cure itself. As prices decreased, demand would
naturally increase, and the economic system would correct itself without
outside intervention.
This view was challenged in the 1930s during the Great Depression. Keynesian economists
argued that the economic system was not self-correcting with respect to
deflation and that governments and central banks had to take active
measures to boost demand through tax cuts or increases in government
spending. Reserve requirements from the central bank were high compared
to recent times. So were it not for redemption of currency for gold (in
accordance with the gold standard), the central bank could have
effectively increased money supply by simply reducing the reserve
requirements and through open market operations
(e.g., buying treasury bonds for cash) to offset the reduction of money
supply in the private sectors due to the collapse of credit (credit is a
form of money).
With the rise of monetarist
ideas, the focus in fighting deflation was put on expanding demand by
lowering interest rates (i.e., reducing the "cost" of money). This view
has received criticism in light of the failure of accommodative policies
in both Japan and the US to spur demand after stock market shocks in
the early 1990s and in 2000–2002, respectively. Austrian economists
worry about the inflationary impact of monetary policies on asset
prices. Sustained low real rates can cause higher asset prices and
excessive debt accumulation. Therefore, lowering rates may prove to be
only a temporary palliative, aggravating an eventual debt deflation
crisis.
Special borrowing arrangements
When
the central bank has lowered nominal interest rates to zero, it can no
longer further stimulate demand by lowering interest rates. This is the
famous liquidity trap. When deflation takes hold, it requires "special arrangements" to lend money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to artificially increase the money supply.
Capital
Although the values of capital assets
are often casually said to deflate when they decline, this usage is not
consistent with the usual definition of deflation; a more accurate
description for a decrease in the value of a capital asset is economic depreciation. Another term, the accounting conventions of depreciation are standards to determine a decrease in values of capital assets when market values are not readily available or practical.
Historical examples
EU countries
The inflation rate of Greece was negative during three years from 2013 to 2015. The same applies to Bulgaria, Cyprus, Spain, and Slovakia from 2014 to 2016. Greece, Cyprus, Spain, and Slovakia are members of the European monetary union. The Bulgarian currency, the lev, is pegged to the Euro with a fixed exchange rate. In the entire European Union and the Eurozone, a disinflationary development was to be observed in the years 2011 to 2015.
Year
Bulgaria
Greece
Cyprus
Spain
Slovakia
EU
Eurozone
2011
3.4
3.1
3.5
3.0
4.1
3.1
2.7
2012
2.4
1.0
3.1
2.4
3.7
2.6
2.5
2013
0.4
−0.9
0.4
1.5
1.5
1.5
1.4
2014
−1.6
−1.4
−0.3
−0.2
−0.1
0.6
0.4
2015
−1.1
−1.1
−1.5
−0.6
−0.3
0.1
0.2
2016
−1.3
0.0
−1.2
−0.3
−0.5
0.2
0.2
2017
1.2
1.1
0.7
2.0
1.4
1.7
1.5
Table: Harmonised index of consumer prices. Annual average rate of change (%) (HICP inflation rate). Negative values are highlighted in colour.
Hong Kong
Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of deflation which did not end until the fourth quarter of 2004. Many East Asian currencies devalued following the crisis. The Hong Kong dollar, however, was pegged to the U.S. dollar, leading to an adjustment instead by a deflation of consumer prices. The situation was worsened by the increasingly cheap exports from mainland China, and "weak consumer confidence"
in Hong Kong. This deflation was accompanied by an economic slump that
was more severe and prolonged than those of the surrounding countries
that devalued their currencies in the wake of the Asian financial
crisis.
Ireland
In February 2009, Ireland's Central Statistics Office
announced that during January 2009, the country experienced deflation,
with prices falling by 0.1% from the same time in 2008. This was the
first time deflation has hit the Irish economy since 1960. Overall
consumer prices decreased by 1.7% in the month.
Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account,
"Minister for Finance Brian Lenihan has said that deflation must be
taken into account when Budget cuts in child benefit, public sector pay
and professional fees are being considered. Mr Lenihan said
month-on-month there has been a 6.6% decline in the cost of living this
year."
This interview is notable in that the deflation referred to is
not discernibly regarded negatively by the Minister in the interview.
The Minister mentions the deflation as an item of data helpful to the
arguments for a cut in certain benefits. The alleged economic harm
caused by deflation is not alluded to or mentioned by this member of
government. This is a notable example of deflation in the modern era
being discussed by a senior financial Minister without any mention of
how it might be avoided, or whether it should be.
Japan
Deflation started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates and "quantitative easing," but did not create a sustained increase in broad money and deflation persisted. In July 2006, the zero-rate policy was ended.
Systemic reasons for deflation in Japan can be said to include:
Tight monetary conditions: The Bank of Japan kept monetary policy loose only when inflation was below zero, tightening whenever deflation ends.
Unfavorable demographics:
Japan has an aging population (22.6% over age 65) which has been
declining since 2011, as the death rate exceeds the birth rate.
Fallen asset
prices: In the case of Japan asset price deflation was a mean reversion
or correction back to the price level that prevailed before the asset
bubble. There was a rather large price bubble in stocks and especially real estate in Japan in the 1980s (peaking in late 1989).
Insolvent companies: Banks lent to companies and individuals that
invested in real estate. When real estate values dropped, these loans
could not be paid. The banks could try to collect on the collateral
(land), but this wouldn't pay off the loan. Banks delayed that decision,
hoping asset prices would improve. These delays were allowed by
national banking regulators. Some banks made even more loans to these
companies that are used to service the debt they already had. This
continuing process is known as maintaining an "unrealized loss", and
until the assets are completely revalued and/or sold off (and the loss
realized), it will continue to be a deflationary force in the economy.
Improving bankruptcy law, land transfer law, and tax law have been
suggested as methods to speed this process and thus end the deflation.
Insolvent banks: Banks with a larger percentage of their loans which
are "non-performing", that is to say, they are not receiving payments
on them, but have not yet written them off, cannot lend more money; they
must increase their cash reserves to cover the bad loans.
Fear of insolvent banks: Japanese people are afraid that banks will
collapse so they prefer to buy (United States or Japanese) Treasury
bonds instead of saving their money in a bank account. This likewise
means the money is not available for lending and therefore economic
growth. This means that the savings rate depresses consumption, but does
not appear in the economy in an efficient form to spur new investment.
People also save by owning real estate, further slowing growth, since it
inflates land prices.
Imported deflation: Japan imports Chinese and other countries'
inexpensive consumable goods (due to lower wages and fast growth in
those countries) and inexpensive raw materials, many of which reached
all time real price minimums in the early 2000s. Thus, prices of
imported products are decreasing. Domestic producers must match these
prices in order to remain competitive. This decreases prices for many
things in the economy, and thus is deflationary.
Stimulus spending: According to both Austrian and monetarist
economic theory, Keynesian stimulus spending actually has a depressing
effect. This is because the government is competing against private
industry, and usurping private investment dollars.
In 1998, for example, Japan produced a stimulus package of more than 16
trillion yen, over half of it public works that would have a quashing
effect on an equivalent amount of private, wealth-creating economic
activity. Overall, Japan's stimulus packages added up to over one hundred trillion
yen, and yet they failed. According to these economic schools, that
stimulus money actually perpetuated the problem it was intended to cure.
In November 2009, Japan returned to deflation, according to The Wall Street Journal. Bloomberg L.P. reports that consumer prices fell in October 2009 by a near-record 2.2%. It was not until 2014 that new economic policies laid out by Prime MinisterShinzo Abe finally allowed for significant levels of inflation to return. However, the COVID-19 recession
once again led to deflation in 2020, with consumer good prices quickly
falling, prompting heavy government stimulus worth over 20% of GDP. As a result, it is likely that deflation will remain as a long-term economic issue for Japan.
United Kingdom
During World War I the Britishpound sterling
was removed from the gold standard. The motivation for this policy
change was to finance World War I; one of the results was inflation, and
a rise in the gold price, along with the corresponding drop in
international exchange rates for the pound. When the pound was returned
to the gold standard after the war it was done on the basis of the
pre-war gold price, which, since it was higher than equivalent price in
gold, required prices to fall to realign with the higher target value of
the pound.
The UK experienced deflation of approximately 10% in 1921, 14% in 1922, and 3 to 5% in the early 1930s.
United States
Annual inflation (in blue) and deflation (in green) rates in the United States since 1666US CPI-U starting from 1913. Source: U.S. Department of Labor
Major deflations in the United States
There have been four significant periods of deflation in the United States.
The first and most severe was during the depression in 1818–1821
when prices of agricultural commodities declined by almost 50%. A credit
contraction caused by a financial crisis in England drained specie out
of the U.S. The Bank of the United States also contracted its lending.
The price of agricultural commodities fell by almost 50% from the high
in 1815 to the low in 1821, and did not recover until the late 1830s,
although to a significantly lower price level. Most damaging was the
price of cotton, the U.S.'s main export. Food crop prices, which had
been high because of the famine of 1816 that was caused by the year without a summer,
fell after the return of normal harvests in 1818. Improved
transportation, mainly from turnpikes, and to a minor extent the
introduction of steamboats, significantly lowered transportation costs.
The second was the depression of the late 1830s to 1843, following the Panic of 1837,
when the currency in the United States contracted by about 34% with
prices falling by 33%. The magnitude of this contraction is only matched
by the Great Depression. (See: § Historical examples of credit deflation.)
This "deflation" satisfies both definitions, that of a decrease in
prices and a decrease in the available quantity of money. Despite the
deflation and depression, GDP rose 16% from 1839 to 1843.
The third was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War:
The Great Sag of 1873–96 could be
near the top of the list. Its scope was global. It featured cost-cutting
and productivity-enhancing technologies. It flummoxed the experts with
its persistence, and it resisted attempts by politicians to understand
it, let alone reverse it. It delivered a generation's worth of rising
bond prices, as well as the usual losses to unwary creditors via
defaults and early calls. Between 1875 and 1896, according to Milton Friedman, prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year.
— Grant's Interest Rate Observer, 10 March 2006
(Note: David A. Wells
(1890) gives an account of the period and discusses the great advances
in productivity which Wells argues were the cause of the deflation. The
productivity gains matched the deflation. Murray Rothbard (2002) gives a similar account.)
The fourth was in 1930–1933 when the rate of deflation was
approximately 10 percent/year, part of the United States' slide into the
Great Depression, where banks failed and unemployment peaked at 25%.
The deflation of the Great Depression occurred partly because there was an enormous contraction of credit (money), bankruptcies creating an environment where cash was in frantic demand, and when the Federal Reserve was supposed to accommodate that demand, it instead contracted the money supply by 30% in enforcement of its new real bills doctrine, so banks failed one by one (because they were unable to meet the sudden demand for cash – see Bank run). From the standpoint of the Fisher equation (see above), there was a simultaneous drop both in money supply (credit) and the velocity of money which was so profound that price deflation took hold despite the increases in money supply spurred by the Federal Reserve.
Minor deflations in the United States
Throughout
the history of the United States, inflation has approached zero and
dipped below for short periods of time. This was quite common in the
19th century, and in the 20th century until the permanent abandonment of
the gold standard for the Bretton Woods system
in 1948. In the past 60 years, the United States has experienced
deflation only two times; in 2009 with the Great Recession and in 2015,
when the CPI barely broke below 0% at −0.1%.
Some economists believe the United States may have experienced deflation as part of the financial crisis of 2007–2008; compare the theory of debt deflation.
Consumer prices dropped 1 percent in October 2008. This was the largest
one-month fall in prices in the U.S. since at least 1947. That record
was again broken in November 2008 with a 1.7% decline. In response, the Federal Reserve decided to continue cutting interest rates, down to a near-zero range as of December 16, 2008.
In late 2008 and early 2009, some economists feared the U.S. would enter a deflationary spiral. Economist Nouriel Roubini predicted that the United States would enter a deflationary recession, and coined the term "stag-deflation" to describe it. It was the opposite of stagflation,
which was the main fear during the spring and summer of 2008. The
United States then began experiencing measurable deflation, steadily
decreasing from the first measured deflation of −0.38% in March, to
July's deflation rate of −2.10%. On the wage front, in October 2009, the
state of Colorado announced that its state minimum wage, which was indexed to inflation, was set to be cut, which would be the first time a state had cut its minimum wage since 1938.
In macroeconomics, inflation targeting is a monetary policy where a central bank follows an explicit target for the inflation
rate for the medium-term and announces this inflation target to the
public. The assumption is that the best that monetary policy can do to
support long-term growth of the economy is to maintain price stability, and price stability is achieved by controlling inflation. The central bank uses interest rates as its main short-term monetary instrument.
An inflation-targeting central bank will raise or lower interest
rates based on above-target or below-target inflation, respectively. The
conventional wisdom
is that raising interest rates usually cools the economy to rein in
inflation; lowering interest rates usually accelerates the economy,
thereby boosting inflation. The first three countries to implement
fully-fledged inflation targeting were New Zealand, Canada and the United Kingdom in the early 1990s, although Germany had adopted many elements of inflation targeting earlier.
History
Early
proposals of monetary systems targeting the price level or the
inflation rate, rather than the exchange rate, followed the general
crisis of the gold standard after World War I. Irving Fisher
proposed a "compensated dollar" system in which the gold content in
paper money would vary with the price of goods in terms of gold, so that
the price level in terms of paper money would stay fixed. Fisher's
proposal was a first attempt to target prices while retaining the
automatic functioning of the gold standard. In his Tract on Monetary Reform (1923), John Maynard Keynes
advocated what we would now call an inflation targeting scheme. In the
context of sudden inflations and deflations in the international economy
right after World War I, Keynes recommended a policy of exchange-rate flexibility,
appreciating the currency as a response to international inflation and
depreciating it when there are international deflationary forces, so
that internal prices remained more or less stable. Interest in inflation
targeting waned during the Bretton Woods era (1944–1971), as they were inconsistent with the exchange rate pegs that prevailed during three decades after World War II.
New Zealand, Canada, United Kingdom
Inflation targeting was pioneered in New Zealand in 1990. Canada was the second country to formally adopt inflation targeting in February 1991.
The United Kingdom adopted inflation targeting in October 1992 after exiting the European Exchange Rate Mechanism. The Bank of England's Monetary Policy Committee was given sole responsibility in 1998 for setting interest rates to meet the Government's Retail Prices Index (RPI) inflation target of 2.5%. The target changed to 2% in December 2003 when the Consumer Price Index (CPI) replaced the Retail Prices Index as the UK Treasury's inflation index.
If inflation overshoots or undershoots the target by more than 1%, the
Governor of the Bank of England is required to write a letter to the Chancellor of the Exchequer explaining why, and how he will remedy the situation. The success of inflation targeting in the United Kingdom has been attributed to the Bank's focus on transparency.
The Bank of England has been a leader in producing innovative ways of
communicating information to the public, especially through its
Inflation Report, which have been emulated by many other central banks.
Inflation targeting then spread to other advanced economies in
the 1990s and began to spread to emerging markets beginning in the
2000s.
European Central Bank
Although the ECB does not consider itself to be an inflation-targeting central bank, after the inception of the euro in January 1999, the objective of the European Central Bank (ECB) has been to maintain price stability within the Eurozone. The Governing Council of the ECB in October 1998 defined price stability as inflation of under 2%, "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%" and added that price stability "was to be maintained over the medium term".
The Governing Council confirmed this definition in May 2003 following a
thorough evaluation of the ECB's monetary policy strategy. On that
occasion, the Governing Council clarified that "in the pursuit of price
stability, it aims to maintain inflation rates below, but close to, 2%
over the medium term".
Since then, the numerical target of 2% has become common for major
developed economies, including the United States (since January 2012)
and Japan (since January 2013).
In 8 July 2021, the ECB changed its inflation target to a
symmetrical 2% over the medium term. Symmetry in the inflation target
means that the Governing Council considers negative and positive
deviations of inflation from the target to be equally undesirable.
Emerging markets
In 2000, Frederic S. Mishkin concluded that "although inflation targeting is not a panacea and may not be appropriate for many emerging market countries, it can be a highly useful monetary policy strategy in a number of them".
Armenia
The
Central Bank of Armenia (CBA) announced in 2006 that it will implement
an inflation targeting strategy. The process of full transition to
inflation targeting was supposed to end in 2008. Operational,
macroeconomic and institutional preconditions for inflation targeting
should have been met to ensure a full transition. CBA believes that it
has managed to meet all the preconditions successfully and should
concentrate on building a public trust in the new monetary policy
regime. A specific model has been developed to estimate CBA's reaction
function and the results showed that the inertia of inflation rate and
interest rate are most vital in the reaction function. This can be an
evidence that the announcement of the strategy is a trustworthy
commitment. Obviously, there are people who claim that inflation
targeting is too restrictive for dealing with positive supply shocks. On
the other hand, the IMF claims that inflation targeting strategy is
good for developing economies, however it requires a lot of information
for forecasting.
The Central Bank continued to pursue a policy of tightening
monetary conditions during the reporting period, increasing the policy
interest rate by a total of 2.75 percentage points. At the same time,
about half of the tightening, 1.25 percentage points, was carried out in
2022 in March, reacting to the high inflation situation formed in the
case of unprecedented uncertainties.
Being constantly hit by external shocks to the national economy
over the past three years, Armenia is still on the path of recovery
thanks to economic management efforts. According to the 3-year Stand-By
Arrangement, which came to its end on May 16, 2022, important structural
and institutional reforms have been implemented. Those include
improvement of tax compliance, budget process refinement, strengthening
the stability of financial sector and most importantly fostering the
inflation targeting framework.
In Chile, a 20% inflation rate pushed the Central Bank of Chile to announce at the end of 1990 an inflation objective for the annual inflation rate for the year ending in December 1991. However, Chile was not regarded as a fully-fledged inflation targeter until October 1999. According to Pablo García Silva,
member of the board of the Central Bank of Chile, this has allowed to
attenuate inflation. García Silva exemplifies this with the limited
inflation seen in Chile during the 2002 Brazilian general election and the Great Recession of 2008–2009.
Czech Republic
The Czech National Bank
(CNB) is an example of an inflation targeting central bank in a small
open economy with a recent history of economic transition and real
convergence to its Western European peers. Since 2010 the CNB uses 2
percent with a +/- 1pp range around it as the inflation target.
The CNB places a lot of emphasis on transparency and communication;
indeed, a recent study of more than 100 central banks found the CNB to
be among the four most transparent ones.
In 2012, inflation was expected to fall well below the target,
leading the CNB to gradually reduce the level of its basic monetary
policy instrument, the 2-week repo rate, until the zero lower bound
(actually 0.05 percent) was reached in late 2012. In light of the
threat of a further fall in inflation and possibly even of a protracted
period of deflation,
on 7 November 2013 the CNB declared an immediate commitment to weaken
the exchange rate to the level of 27 Czech korunas per 1 euro
(day-on-day weakening by about 5 percent) and to keep the exchange rate
from getting stronger than this value until at least the end of 2014
(later on this was changed to the second half of 2016). The CNB thus
decided to use the exchange rate as a supplementary tool to make sure
that inflation returns to the 2 percent target level. Such a use of the
exchange rate as tool within the regime of inflation targeting should
not be confused with a fixed exchange-rate system or with a currency war.
United States
In a historic shift on 25 January 2012, U.S. Federal Reserve Chairman Ben Bernanke set a 2% target inflation rate, bringing the Fed in line with many of the world's other major central banks. Until then, the Fed's policy committee, the Federal Open Market Committee
(FOMC), did not have an explicit inflation target but regularly
announced a desired target range for inflation (usually between 1.7% and
2%) measured by the personal consumption expenditures price index.
Prior to adoption of the target, some people argued that an
inflation target would give the Fed too little flexibility to stabilise
growth and/or employment in the event of an external economic shock. Another criticism was that an explicit target might turn central bankers into what Mervyn King, former Governor of the Bank of England, had in 1997 colorfully termed "inflation nutters"—that
is, central bankers who concentrate on the inflation target to the
detriment of stable growth, employment, and/or exchange rates. King went
on to help design the Bank's inflation targeting policy,
and asserts that the buffoonery has not actually happened, as did
Chairman of the U.S. Federal Reserve Ben Bernanke, who stated in 2003
that all inflation targeting at the time was of a flexible variety, in
theory and practice.
Former Chairman Alan Greenspan, as well as other former FOMC members such as Alan Blinder,
typically agreed with the benefits of inflation targeting, but were
reluctant to accept the loss of freedom involved; Bernanke, however, was
a well-known advocate.
In August 2020, the FOMC released a revised Statement on Longer-Run Goals and Monetary Policy Strategy.
The review announced the FED would seek to achieve inflation that
'averages' 2% over time. In practice this means that following periods
when inflation has been running persistently below 2 percent,
appropriate monetary policy will likely aim to achieve inflation
moderately above 2 percent for some time.
This way, the fed hopes to better anchor longer-term inflation
expectations, which they say would foster price stability and moderate
long-term interest rates and enhance the Committee's ability to promote
maximum employment in the face of significant economic disturbances.
Theoretical questions
New classical macroeconomics and rational expectations hypothesis
can explain how and why inflation targeting works. Expectations of
firms (or the subjective probability distribution of outcomes) will be
around the prediction of the theory itself (the objective probability
distribution of those outcomes) for the same information set.
So, rational agents expect the most probable outcome to emerge.
However, there is limited success at specifying the relevant model, and
the full and perfect knowledge of a given macroeconomic system can be
regarded as a comfortable presumption at best. Knowledge of the relevant
model is not feasible, even if high-level econometrical techniques were
accessible or adequate identification of the relevant explanatory
variables were performed. So, estimation bias depends on the quantity
and quality of information to which the modeller has access. In other
words, estimations are asymptotically unbiased with respect to the
exploited information.
Meanwhile, consistency can be interpreted similarly. On the basis
of asymptotical unbiasedness, a moderated version of the rational
expectations hypothesis can be suggested in which familiarity with the
theoretical parameters is not a requirement for the relevant model. An
agent with access to sufficiently vast, quality information and
high-level methodological skills could specify its own quasi-relevant
model describing a specific macroeconomic system. By increasing the
amount of information processed, this agent could further reduce its
bias. If this agent were also focal, such as a central bank, then other
agents would likely accept the proposed model and adjust their
expectations accordingly. In this way, individual expectations become
unbiased as much as possible, albeit against a background of
considerable passivity. According to some researches, this is the
theoretical background of the functionality of inflation targeting
regimes.
Empirical issues
Target band size
While
most inflation targeting countries set their target band at 2
percentage points, the band sizes are wide-ranging across countries and
inflation targeters frequently update their target bands.
Track record
Inflation
targeting countries' track records in maintaining inflation within the
central banks' target bands differ substantially and financial markets
differentiate inflation targeters by behaviors.
Debate
There is some empirical evidence
that inflation targeting does what its advocates claim, that is, making
the outcomes, if not the process, of monetary policy more transparent. A 2021 study in the American Political Science Review
found that independent central banks with rigid inflation targeting
policies produce worse outcomes in banking crises than independent
central banks whose policy mandate does not rigidly prioritize
inflation.
Benefits
Inflation targeting allows monetary policy to "focus on domestic considerations and to respond to shocks to the domestic economy", which is not possible under a fixed exchange-rate system. Also, as a result of better inflation control and stability of economic growth, investors may more easily factor in likely interest rate changes into their investment decisions. Inflationexpectations that are better anchored "allow monetary authorities to cut policy interest rates countercyclically".
Transparency is another key benefit of inflation targeting.
Central banks in developed countries that have successfully implemented
inflation targeting tend to "maintain regular channels of communication
with the public". For example, the Bank of England
pioneered the "Inflation Report" in 1993, which outlines the bank's
"views about the past and future performance of inflation and monetary
policy".
Although it was not an inflation-targeting country until January 2012,
up until then, the United States' "Statement on Longer-Run Goals and
Monetary Policy Strategy" enumerated the benefits of clear
communication—it "facilitates well-informed decisionmaking by households
and businesses, reduces economic and financial uncertainty, increases
the effectiveness of monetary policy, and enhances transparency and
accountability, which are essential in a democratic society".
An explicit numerical inflation target increases a central bank's accountability, and thus it is less likely that the central bank falls prey to the time-inconsistency
trap. This accountability is especially significant because even
countries with weak institutions can build public support for an
independent central bank. Institutional commitment can also insulate the
bank from political pressure to undertake an overly expansionary
monetary policy.
An econometric
analysis found that although inflation targeting results in higher
economic growth, it does not necessarily guarantee stability based on
their study of 36 emerging economies from 1979 to 2009.
Shortcomings
Supporters of a nominal income target criticize the propensity of inflation targeting to neglect output shocks by focusing solely on the price level. Adherents of market monetarism, led by Scott Sumner, argue that in the United States, the Federal Reserve's
mandate is to stabilize both output and the price level, and that
consequently a nominal income target would better suit the Fed's
mandate. Australian economist John Quiggin,
who also endorses nominal income targeting, stated that it "would
maintain or enhance the transparency associated with a system based on
stated targets, while restoring the balance missing from a monetary
policy based solely on the goal of price stability". Quiggin blamed the late-2000s recession
on inflation targeting in an economic environment in which low
inflation is a "drag on growth". In practice, many central banks conduct
"flexible inflation targeting" where the central bank strives to keep
inflation near the target except when such an effort would imply too
much output volatility.
Quiggin also criticized former Fed Chair Alan Greenspan and former European Central Bank President Jean-Claude Trichet for "ignor[ing] or even applaud[ing] the unsustainable bubbles in speculative real estate that produced the crisis, and to react[ing] too slowly as the evidence emerged".
In a 2012 op-ed, University of Nottingham economist Mohammed Farhaan Iqbal suggested that inflation targeting "evidently passed away in September 2008", referencing the 2007–2012 global financial crisis.
Frankel suggested "that central banks that had been relying on
[inflation targeting] had not paid enough attention to asset-price bubbles", and also criticized inflation targeting for "inappropriate responses to supply shocks and terms-of-trade
shocks". In turn, Iqbal suggested that nominal income targeting or
product-price targeting would succeed inflation targeting as the
dominant monetary policy regime.
The debate continues and many observers expect that inflation targeting
will continue to be the dominant monetary policy regime, perhaps after
certain modifications.
Empirically, it is not so obvious that inflation targeteers have
better inflation control. Some economists argue that better institutions
increase a country's chances of successfully targeting inflation.
As regards the impact of the 2007–2012 financial crisis, John Williams,
a high-ranking Federal Reserve official, concludes that "when gauged by
the behavior of inflation since the crisis, inflation targeting
delivered on its promise".
In an article written since the COVID-19 pandemic, critics have pointed out that the Bank of Canada’s
inflation-targeting has had unintended consequences, with persistently
low interest rates over the last 12 years fuelling an increase in home
prices by encouraging borrowing; and contributing to wealth inequalities
by supporting higher equity values.
Choosing a positive, zero, or negative inflation target
Choosing a positive inflation target has at least two drawbacks.
Over time, the compounded effect of small annual price increases
will significantly reduce a currency's purchasing power. (For example,
successfully hitting a target of +2% each year for 40 years would cause
the price of a $100 basket of goods to rise to $220.80.) This drawback would be minimized or reversed by choosing a zero inflation target or a negative target.
Vendors must expend resources more frequently to reprice their goods
and services. This drawback would be minimized by choosing a zero
inflation target.
However, policymakers feel the drawbacks are outweighed by the fact
that a positive inflation target reduces the chance of an economy
falling into a period of deflation.
Some economists argue that fear of deflation is unfounded, citing
studies that show inflation is more likely than deflation to cause an economic contraction. Andrew Atkeson and Patrick J. Kehoe wrote,
According to standard economic theory, deflation is the necessary consequence of optimal monetary policy. In 1969, Milton Friedman
argued that under the optimal policy, the nominal interest rate should
be zero and the price level should fall steadily at the real rate of
interest. Since then, Friedman’s argument has been confirmed in a formal
setting. (See, for example, V. V. Chari, Lawrence Christiano, and
Patrick Kehoe 1996 and Harold Cole and Narayana Kocherlakota 1998.)
Effectively, Friedman was arguing for a negative (moderately deflationary) inflation target.
Numerical target
The
typical numerical target of 2% has come under debate since the period
of rapid inflation experienced following the monetary expansion during
the COVID-19 pandemic.
Mohamed El-Erian
has suggested the Federal Reserve raise its inflation target to a
(stable) 3% rate of inflation, saying "There's nothing scientific about
2%".
Variations
In contrast to the usual inflation rate targeting, Laurence M. Ball proposed targeting long-run inflation using a monetary conditions index.
In his proposal, the monetary conditions index is a weighted average of
the interest rate and exchange rate. It will be easy to put many other
things into this monetary conditions index.
In the "constrained discretion" framework, inflation targeting
combines two contradicting monetary policies—a rule-based approach and a
discretionary approach—as a precise numerical target is given for
inflation in the medium term and a response to economic shocks in the
short term. Some inflation targeters associate this with more economic
stability.
Countries
There were 27 countries regarded by the Bank of England's Centre for Central Banking Studies as fully fledged inflation
targeters at the beginning of 2012. Other lists count 26 or 28 countries as of 2010. Since then, the United States and Japan have also adopted inflation
targets although the Federal Reserve, like the European Central Bank, does not consider itself to be an inflation-targeting central bank.
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