Stephen King: Aim of the game for the Fed is to avoid deflation

Had the Bank of Japan known what would happen it could have cut rates more aggressively

In Formula 1, I'm told, tyres matter. Apparently, there are tyres for wet weather and there are tyres for dry weather. When it's raining, you choose the wet weather tyres. Otherwise the lack of grip will leave you spinning all over the place. When it's dry, you need the "slicks" to ensure that you can achieve maximum speed.

But what if the weather's changeable? What happens if, one minute it's raining, the next it's sunny and dry? Then which tyres do you choose? Choose well and you may win the race. Choose badly and you may end up in the crash barrier.

Policy makers are facing similar dilemmas. In the mid-1990s, decisions on interest rates seemed relatively straightforward. With growth moving ahead smoothly, with a general absence of severe inflationary pressures and with no nasty external shocks, a gentle adjustment of interest rates here or there was all that was required. Even when external shocks did come along – in the form of the Asian crisis and Russian debt default – the absence of serious inflationary pressures made policy adjustment relatively straightforward. Rates came down, activity rebounded and the global economy was saved.

Now, however, we're back into the changeable conditions that give central bankers such headaches. Economies are recovering but equity markets are weak. House prices are going up but, in the US at least, consumer spending has slowed. Business surveys suggest activity is better but the businesses themselves are not prepared to declare that recovery is underway.

Of course, it could be argued that these apparent inconsistencies are precisely what you tend to see at the beginning of economic recovery. Some areas look better, others look worse. That's all fine enough but the problem today is the order of events. Typically, one of the first things to improve as recession comes to an end is the equity market. This time around, that clearly hasn't happened.

That leaves central banks with a series of difficult choices. The cyclical recovery in economic activity has surprised on the upside. This might suggest that at least some of last year's interest rate cuts should be taken back. Yet the persistent decline in equities might suggest a failure of monetary policy to work, thereby suggesting that interest rates should be cut even further. Put another way, should central banks be worrying about future inflation on the back of cyclical recovery? Or should they be worrying more about future deflation on the back of persistent asset price weakness?

If you look on the Federal Reserve's website (www.federalreserve.gov) you'll find a rather useful paper on this subject. Entitled Preventing Deflation: Lessons from Japan's Experience in the 1990s, it's written by a team of Federal Reserve economists who have tried to find out what the Japanese authorities could have done – admittedly with the benefit of hindsight – to prevent deflation from occurring.

The writers attempt to pass judgement on the Bank of Japan using two different approaches. In the first approach, they attempt to work out whether the Bank of Japan was slow in cutting interest rates on the basis of the forecasts that formed part of the economics consensus in the early 1990s. On the basis of these – ultimately wrong – forecasts they conclude that the Bank of Japan didn't do such a bad job after all on monetary policy. Rates came down fairly quickly given the prevailing expectations on growth and inflation within financial markets: it's just unfortunate that these expectations were wrong.

Their second approach – a great example of using hindsight – is to see whether the Bank of Japan did the right thing not so much on the basis of the expectations at the time but rather by working back from the actual subsequent events. The Federal Reserve economists conclude that, had the Bank of Japan known what was going to happen to the economy, it could have cut rates a lot more aggressively and, hence, stave off at least some of the risks of subsequent deflation (not surprisingly, the Fed's economists have faith in the idea that some level of interest rates would have rescued Japan, a point that might be debated given the excesses of the bubble in the late 1980s).

The point about this comparison is that sometimes central banks may need to think outside of the box provided by their econometric models and the box provided by the economics community at large. Basically, everyone's forecasts were wrong and the consensus was way too confident about the ability of Japan's economy to recover. The Bank of Japan – and the economics community at large – spent too much time worrying about inflation and not enough time worrying about the possibility – however remote it seemed at the time – of deflation.

If there is a message from this analysis, it is that virtually everyone contributed to Japan's failure in the 1990s. Anyone who talked about deflation in the first half of the 1990s was regarded as a maverick not to be taken seriously.

The good news is that the Federal Reserve thinks that there are lessons to be learnt from this period. In particular, the paper points out that, if a country is faced with a series of shocks, some of which may be inflationary and some of which may be deflationary, it is far better to steer monetary policy towards the avoidance of deflation rather than the prevention of inflation. The reason is simple. When deflation arrives, monetary policy stops working. Given that cash provides a zero nominal interest rate, any move towards falling prices in effect ensures that real rates rise, thereby preventing recovery from coming through. If higher inflation is a potential consequence of an anti-deflation strategy, it may be a price worth paying, if only because monetary policy can subsequently be adjusted to deal with any pick-up in inflation.

The relevance of this message for today is obvious. We cannot be sure that falling equity prices will ultimately lead to deflation. Nor can we be sure that rising house prices will eventually lead to inflation. But we know that, of the two options, inflation is ultimately easier to deal with.

This, though, creates a dilemma. A vigorous attempt to stick to a very low inflation target could prevent central banks from pursuing the kind of policy that might be consistent with deflation avoidance (if, indeed, such a policy actually exists). One way to get around this would simply be for central banks to be more flexible in their treatment of inflation targets although whether the appetite for this flexibility exists is questionable at this stage.

Where does that leave us? We know that the world is unusually complicated at the moment. We know that asset prices are moving in all sorts of different ways. We know that inflation is already very low. Despite all this, what we don't yet have is a significant debate about the risks of deflation. And it was the absence of just such a debate that contributed to Japan's economic demise at the beginning of the 1990s. However, it seems to me that the Federal Reserve is adopting an anti-deflation strategy. Yes, the US economy appears to be recovering. But like the Formula 1 team, I think the Fed has chosen its monetary policy tyres: interest rates at current levels for the foreseeable future with deflation avoidance the aim of the game.

Stephen King is managing director of economics at HSBC