NCPA - National Center for Policy Analysis

Deflation and Zero Percent Interest Rates

December 10, 2001

The Federal Open Market Committee of the Federal Reserve may cut the federal funds interest rate by another 25 basis points (0.25 percent), reducing it from 2 percent to 1.75 percent, its lowest level since 1961.

Lower interest rates should increase borrowing, investment and consumption, thereby stimulating economic growth. However, Japan's central bank has cut the equivalent of the fed funds rate virtually to zero. Yet borrowing has not been stimulated and the economy has been mired in recession for many years.

One explanation for the Japanese experience is that lower interest rates have not been accompanied by an increase in monetary liquidity. In effect, monetary policy remains tight despite the low nominal interest rates, putting deflationary pressure on the economy. With the price level falling in Japan, even very low market interest rates can be high in real terms.

If the price level is falling 3 percent per year and the nominal interest rate is 2 percent, the real interest rate is 5 percent. Even a zero percent market rate, as Japan has, would still yield a real interest rate of 3 percent -- equal to the deflation rate.

Of course, the steeper the deflation rate, the higher real interest rates become. Thus deflation severely discourages borrowing and lending. It also discourages spending, as consumers wait for prices to fall further before buying.

Technically, what happens is that the velocity of money -- the number of times a given dollar is spent -- falls during a deflation (see figure).

  • Economist David Gitlitz of points out that despite recent increases the Dow Jones Spot Commodities Index is down 12 percent so far this year, and the Commodity Research Bureau Futures Index is down 16 percent.
  • Gold, oil and even car prices are all falling.
  • This deflationary pressure is sharply reducing velocity, negating the effects of the Fed's interest rate cuts.

Although some economists are starting to predict an early recovery next year, those who believe the U.S. economy is suffering from deflation are much less sanguine. Until the Fed adds enough liquidity to the economy to stop commodity prices from falling, they believe, a sustained recovery cannot begin.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, December 10, 2001.


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