Downside Danger

Why the world's central banks must become more vigilant about falling prices.

If a single proposition unites central bankers these days, it is the belief that price stability -- in practice, a low and stable rate of inflation -- is the bedrock of sound monetary policy. To someone with only a passing knowledge of monetary and economic history, this idea may seem unprogressive, if not downright Victorian. In fact, its validity has been demonstrated, painfully, many times.

There is now a consensus among economic historians that a particular form of price instability -- deflation, or falling prices -- was a principal cause of the Great Depression. And nearly all economists agree that the inflationary surge in the United States, the United Kingdom, and several other countries from the late 1960s through the early 1980s was an important source of the economic volatility, slow growth, and high unemployment that characterized those years.

Determined to avoid a repeat of the Great Inflation of the 1970s, central bankers around the world have worked hard over the last two decades to achieve price stability. The U.S. Federal Reserve has reduced inflation from more than 13 percent in 1979 to the low single digits today. As part of the anti-inflation campaign, many central banks have adopted quantitative inflation objectives, including several banks, such as the European Central Bank (ECB), that do not formally classify themselves as "inflation targeters."

Nearly all industrialized nations currently have inflation rates of around 2 percent, the important exception being Japan, which is experiencing a mild deflation. Even regions traditionally prone to high inflation have substantially reduced their inflation rates. For instance, many countries in Latin America now boast rates well below 10 percent; very few have rates above 20 or 30 percent, a once common level.

Low and stable inflation in many countries is an important accomplishment that will continue to bring significant benefits. But de facto price stability has had another effect, which is now forcing central bankers, as well as the public, to fundamentally rethink inflation.

After a long period in which the desired direction for inflation was always downward, the industrialized world's central banks must today try to avoid major changes in the inflation rate in either direction. In central bank speak, we now face "symmetric" inflation risks. The Federal Reserve recognized the changed circumstances in a statement issued following the May 6, 2003 meeting of its policymaking arm, the Federal Open Market Committee (FOMC). The FOMC explicitly recognized that both upside and downside risks to inflation can exist and said the greater risk at this moment is on the downside. It was the first time in decades, if not ever, that the central bank has voiced concern that inflation might fall too low.

Why would very low inflation -- say, below 1 percent -- or actual deflation (negative inflation, or falling prices) possibly hurt the economy?

The potential harm of very low inflation or deflation depends on the economic environment. Deflation can be particularly dangerous when a financial system is shaky, with household and corporate balance sheets in poor shape and banks undercapitalized and heavily burdened with bad loans. Under such conditions, deflation increases the real burden of debts -- that is, it forces borrowers to repay in dollars that are more expensive than the dollars they borrowed -- and may exacerbate the financial distress. (Unexpectedly low inflation has a similar effect.) This phenomenon, known as "debt deflation," factored prominently in the global economic turmoil of the 1930s and may have played an important role in Japan's recent troubles. Fortunately, the United States does not appear at risk of suffering a similar financial setback. American households and firms have done an excellent job in recent years of restructuring their balance sheets, and U.S. banks are well capitalized and profitable.

Although the U.S. financial system is sound, circumstances exist under which deflation or very low inflation might still conceivably pose a significant threat to the economy. The potential problem could arise when aggregate spending by households and firms is insufficient to sustain strong economic growth, even when the short-term real interest rate (the market, or nominal, interest rate minus the rate of inflation) is zero or negative.

When aggregate demand is that weak, deflation or very low inflation places a lower limit on the real interest rate that can be engineered by monetary policymakers -- in other words, it hinders the ability of a central bank to stimulate growth. That is because the nominal rate of interest cannot go below zero. No one will lend at a negative interest rate; potential creditors will simply choose to hold cash, which pays zero nominal interest.

The U.S. economy appears to be rebounding, in part because the Federal Reserve has kept interest rates low. I expect the recovery to continue. But were it to falter -- say, because firms cut back on new investment -- then the scenario just described might become relevant. Specifically, if spending and output growth next year proved insufficient to absorb the slack in labor and product markets, we might see further reductions in inflation, which would further restrict the Federal Reserve's already limited ability to lower the short-term real interest rate.

There are other ways the central bank can stimulate the economy. For example, it can purchase a broad range of financial assets, thereby pumping additional liquidity into the economy. However, the Federal Reserve has less experience using these methods and in predicting their effects, so implementing them would not be without cost. Hence, allowing inflation to fall too low -- low enough to where it might morph into actual deflation -- would be highly undesirable from the point of view of the Federal Reserve, or any other central bank for that matter.

In short, inflation can be too high, but it can also be too low. So what level of inflation is just right -- what, if you will, is the "Goldilocks" level? The best-case scenario is when inflation is neither so high as to impede economic efficiency and growth nor so low that the nominal short-term interest rate routinely flirts with zero. What that ideal inflation rate is depends on the individual economy and on the views and preferences of policymakers.

Although the "just right" inflation rate for the U.S. economy remains an open question, much recent research suggests that it is around 2 percent. Japan's negative inflation rate is clearly too low for the country's economic health. Until recently, the ECB's inflation objective was a rate below 2 percent, leading some observers to worry that the bank was perhaps giving insufficient attention to the downward risks to inflation. Lately, however, the ECB has stated that it intends to keep inflation near 2 percent, which suggests that it is now taking a more symmetric view of inflation risks.

The conquest of inflation is an important victory for the world's central banks and a critical factor behind the improvement in economic performance over the last two decades. To continue to promote economic growth and stability in coming decades, monetary authorities will need to exercise the same vigilance with respect to the downside risks to inflation.


Pragmatists in Tehran

As the United States negotiates with Iran, it needs to jettison preconceptions about what negotiating with Iran means.

Tehran’s initial oral response to International Atomic Energy Agency Director General Mohamed ElBaradei’s proposal to send most of Iran’s current stockpile of low enriched uranium (LEU) abroad for processing into fuel rods for its reactor in Tehran, indicates three important things about the Islamic Republic’s strategic perspective.  First, Iran is interested in establishing a framework for international cooperation to develop its civil nuclear program.  President Mahmoud Ahmadinejad made this clear in an important speech on Oct. 29.

Second, Iran remains profoundly interested in creating a framework for broader strategic cooperation, especially with the United States. This has been a consistent objective in Iran’s interactions with the United States for several years, across ideologically diverse Iranian administrations, including the current Ahmadinejad administration. 

Third, Iran might be willing to address international concerns about its nuclear program by sending portions of its LEU stockpile out of the country for futher, value-adding processing, in the process, making the management of the stockpile more transparent to the international community. However, Tehran will only do this if it is confident that other international parties will follow through on their commitments and that cooperation with those parties will not leave the Islamic Republic more vulnerable to international pressure.

It is important to keep in mind that Iran had originally proposed to refuel the Tehran research reactor through purchasing fuel assemblies from international providers, including the United States -- in fact, involving the United States was Iran’s idea of a confidence-building measure. There was a clear consensus within the Iranian leadership in support of this proposal, with President Ahmadinejad speaking about it publicly.

The United States responded with interest to Iran’s initiative but proposed, instead, that Iran ship most of Iran’s low enriched uranium stockpile outside the country for fabrication into fuel rods for the reactor in question. From an Iranian perspective, there are two potential flaws with this approach. First, Iran’s experience of prior cooperation with international actors on its nuclear program has been disappointing. During the 1970s, Iran invested more than $1 billion to build a French reactor which was contractually supposed to guarantee Iran access to that reactor’s fuel. But, when the Islamic Republic was established, France reneged. Now Iran is being called on to trust France, again, to return its fuel.

Second, at Iran’s current production rate for low enriched uranium, it would take Tehran nine to 12 months to replenish the uranium that would be sent out of the country under this deal, if it were sent out in a single batch. For serious national security planners in Tehran, whether they like Ahmadinejad or not, this is potentially problematic as it leaves almost a year’s window of increased vulnerability to an Israeli or U.S. military attack.

In Tehran, views are split, and it has nothing to do with reformists vs. hardliners, or the pro-Ahmadinejad camp vs. the anti-Ahmadinejad camp. It has to do with lack of confidence about U.S. and Israeli intentions toward the Islamic Republic as it is constituted, rather than as we wish it to be.  In this regard, action by two Congressional committees this week to pass legislation authorizing additional U.S. unilateral sanctions against Iran and non-U.S. companies doing business there will only do further damage to Iranian perceptions of American intentions and President Obama’s seriousness about engaging Tehran.

Too often, Iran’s security concerns are dismissed in the United States and Israel as false or manufactured, re-enforcing the stereotype of Iranians as chronically duplicitous and unprepared to keep any commitment they enter into. These stereotypes are unfortunate for two reasons. First, they are wrong and simply not supported by the historical record. This is certainly not how Iran approached previous episodes of engagement with the United States – including two years of extremely constructive official talks between the United States and Iran over Afghanistan and al Qaida following the 9/11 attacks (talks in which I directly participated).

Second, these stereotypes are fundamentally racist. If someone were to criticize Israeli diplomacy by referring to rabbis lying and conspiring behind their beards -- as far too many commentators accuse Iran’s “mullahs” as lying and conspiring behind their beards -- we would rightly denounce that as an anti-Semitic stereotype.

We should not approach negotiations with Iran on the basis of stereotypes. We should approach these negotiations with a serious understanding of our own interests and an informed appreciation for the interests of the other side.

In beginning this process, the United States has two choices. One is continuing to insist on strict quantitative limits on the further expansion of Iran’s fuel cycle infrastructure as the price Iran must pay to continue talks, and on the complete suspension of Iran’s uranium enrichment activities as the price Iran would have to pay for a longer-term deal.

This is clearly the approach preferred by some in Washington, some of Israel’s supporters here, and the current Israeli government. Israeli Prime Minister Benjamin Netanyahu has made clear, publicly, that full suspension of Iran’s fuel-cycle development is the only acceptable outcome to nuclear dialogue with the Islamic Republic. But it is dangerous and delusionary. If, in the near term, the United States insists on strict quantitative limits on further development of Iran’s fuel cycle infrastructure, and, in the longer term, on zero enrichment in Iran, the negotiating process started in Geneva on October 1 will implode.

That implosion will put the United States on the path to policy failure as it seeks to impose what Sec Clinton likes to call “crippling” sanctions on Iran. And when the U.S. is unable to get Chinese or Russia, or even French, support for anything approaching “crippling” sanctions, that policy failure will increase the chances for military confrontation over Iran’s nuclear activities with all of the predictably profound consequences such a confrontation would have for the Middle East, especially for Israel.

The other, far more preferable, approach would entail the United States pursuing a genuinely workable diplomatic strategy towards Iran. With regard to the nuclear issue, this would mean stepping back from a quixotic quest for zero enrichment in Iran and, instead, seeking to identify monitoring arrangements for Iran’s nuclear program so that the proliferation risks associated with Iran’s program were tightly controlled.

Pursuing this strategy would also require embedding diplomatic efforts on the nuclear issue in a broader, comprehensive, strategic framework for U.S.-Iranian discussions. Such discussions would deal with the full range of bilateral differences between Washington and Tehran, with the aim of reaching what I have often described as a U.S.-Iranian Grand Bargain. This is something which Iran very much wants. It is also something that would be very strongly in the interests of the United States and Israel.

The idea of a U.S.-Iranian “grand bargain” starts from the premise that Iran is not just a problem to be managed. In much the same way that President Richard Nixon understood that strategic rapprochement with the People’s Republic of China was imperative for American interests in the early 1970s, strategic rapprochement with the Islamic Republic is now truly imperative for American interests in the Middle East.

At this point, the United States cannot achieve any of its high-priority objectives in the greater Middle East -- in the Arab-Israeli arena, Lebanon, Iraq, Afghanistan, with regard to energy security, etc. -- without a more productive relationship with the Islamic Republic.

Of course, the opening to China had important implications for America’s established allies in Asia -- most notably, Japan -- in much the same the way some fear an American opening to Iran would have negative implications for Israel. But the U.S.-Japan alliance not only survived America’s rapprochement with China -- in fact, the consolidation of a largely cooperative Sino-American relationship profoundly reduced the security threat to Japan emanating from China.

For those in Israel and her supporters here who believe that a U.S.-Iranian “grand bargain” would inevitably be struck at the expense of Israel’s interests, I would say two things: First, Israel’s interest would also be profoundly well served by a U.S.-Iranian rapprochement that helped to settle the unresolved tracks of the Arab-Israeli conflict, put Iraq and Afghanistan on more stable trajectories, and effectively eliminated the risk of U.S.-Iranian (or Israeli-Iranian) military confrontation.

Second, without U.S.-Iranian rapprochement, the United States will not be able to achieve any of its high-priority goals in the Middle East.  This would be bad for Israel, which needs credible and effective American leadership in the region to maintain a stable balance of power, address serious threats, and ensure its safety and survival.  We should think hard about what Israel’s strategic situation would be like if the United States is seen, to a much greater extent than is already the case, as a declining power, unable to deliver.