The link between deflation and economic growth

The BIS came out with their Quarterly Review swinging with some provocative statements about the current wisdom in macroeconomics. There has been a clear focus on the key link between deflation and economic growth. This perceived link currently seems to drive markets as many believe that deflation is both a signal and a cause of the global economic slowdowns.

This deflation growth link seems to be a extension of the old Phillips Curve trade-off discussion between inflation and economic growth. The old (pre-rational expectations view) was that higher inflation was caused or a clear signal of higher economic growth given economic utilization was above the natural rate. Slowing growth would cause a slowdown in inflation. There was a trade-off. The problem with that view was the 70's period of stagflation. Now 40 years later, there is the view that falling inflation retards growth and signals that there is slack in the economy. Of course, this is a simplification, but it provides a framework that is used by many investors. Clearly, low inflation or deflation affects the ability of central banks to control real rates especially when rates are low. Nominal rates can be take to zero but have a hard time going lower. We are finding out this is not the case; however,  there is a more complex story. The evidence suggests that the deflation is not the driver of slow growth.

The key is not in deflation of prices but deflation in property and assets, but even here the story is not so simple. The financial cycle of boom and bust drives the growth story not overall prices. The solutions are complex. Controlling financial growth will stop the bust, but requires strong policy choices to mitigate cycles.