On most  2  BIS central bankers’ speeches  estimates of the various sensitivities the second effect will dominate the first and consumption should actually rise 1, even before those price cuts actually arrive. Conversely, if all prices fall simultaneously, including the price of labour (the nominal wage), then there’s no boost to real income to offset any increased tendency to save. Not only that, falls in nominal income would also expose the economy to a potentially much more serious risk, namely a rising burden of debt. Because the principal is fixed in nominal terms, shortfalls in cash income make debts harder to service, increasing the risk of financial instability and the pressure on debtors to cut back spending. It’s this “debt deflation” channel, emphasised originally by Irving Fisher and studied in depth by Ben Bernanke, amongst others, that is thought to have been the main cost of falling prices and wages during the Great Depression. It’s therefore important to understand whether “deflation” is happening simply because there’s been a sharp drop in the price of something we buy – oil, say – or whether it’s a more generalised phenomenon in which nominal incomes too are falling. The other important factor is interest rates. The incentive to save depends not on inflation expectations per se but on the (ex ante) real rate of interest.
5  If deflations per se were costly you’d expect to see Charts 3 and 4 become shallower south of the origin. 4  BIS central bankers’ speeches  Chart 3 Those deflations no more costly than other disinflations…  Chart 4 …same was true for wage growth  Source: ONS and Hills,Thomas, Dimsdale (2010). Source: ONS and Hills,Thomas, Dimsdale (2010). Chart 5 Interest rate unconstrained by zero bound  But what must also have been important, it seems to me, is that the appropriate level of real interest rates was sufficiently high through the period that monetary policy never had to contend with the zero lower bound on the nominal rate 6. Chart 5 adds to Chart 2 the series for Bank Rate, in green. The real short-term interest rate – which we know, after the event, can’t have deviated that much from the level necessary to sustain stable growth and prices (since that’s what generally occurred) – averaged 4% between 1850 and 1914. If the neutral real rate is anything like that high, only a very severe deflation would drag the appropriate nominal rate close to zero. As it was, Bank Rate was unconstrained from responding to lower nominal growth 7, when that occurred, and never fell below 2%. Source: ONS and Hills,Thomas, Dimsdale (2010). 6  By “zero” I mean the effective lower bound on nominal interest rates; this may not be precisely zero.