WSJ: Amid Pressing Problems, Threat of Deflation Looms
Zolpot
Oct. 18, 2008
Amid Pressing Problems, Threat of Deflation Looms
By SUDEEP REDDY
Policy makers navigating the U.S. through the global credit crisis may
have a new concern on the horizon for 2009: deflation.
The risk of deflation -- generally falling prices across the economy,
beyond volatile energy and food costs -- remains slim. But the
financial shock and a faltering economy can set the stage for a
deflationary environment.
Federal Reserve officials view broad-based deflation as unlikely but
possible. Federal Reserve Bank of San Francisco President Janet Yellen
said in a speech this week that the plunge in oil prices along with
slackening demand for labor and goods should "push inflation down to,
and possibly even below, rates that I consider consistent with price
stability."
Fed officials generally consider price stability to be an inflation
rate between 1.5% and 2%. Their preferred measure of core inflation,
which excludes food and energy, stands above 2% now, and is expected
to remain above that mark as price increases from earlier this year
advance through the product pipeline.
The economic slowdown and declining commodity prices have eased the
nation's consumer inflation rate, which surged to 5.6% over the
summer. Annual inflation in the U.S. is likely to turn negative for at
least several months next year, on declining energy and food prices.
With the unemployment rate rising rapidly and capital markets in
turmoil, "pretty much everything points toward deflation," said Paul
Ashworth, chief U.S. economist at Capital Economics. "The only thing
you can hope is that the prompt action of policy makers can maybe head
this off first."
The Japanese economy in the 1990s and the U.S. during the 1930s
illustrate how deflation can choke a weak economy and spiral out of
control. A sagging economy exerts downward pressure on prices because
of weak demand for labor and goods. Broad-based declines --
particularly in a credit crisis, which can push asset prices down
sharply -- can also force down wages, preventing consumers and,
therefore, companies from paying their debts. Falling prices also
encourage businesses and consumers to save rather than spend, because
money would be worth more after prices decline. The restrained
spending, in turn, hurts the economy even more.
Federal Reserve Chairman Ben Bernanke, in a speech as a Fed governor
in 2002, said deflation in the U.S. is "highly unlikely" but added, "I
would be imprudent to rule out the possibility altogether." The
reason, he said at the time, was the Fed "has sufficient policy
instruments to ensure that any deflation that might occur would be
both mild and brief."
The government has taken extraordinary measures in recent months to
stem the credit crisis and further action is expected to keep the
economy from becoming too weak to benefit from monetary and fiscal
stimulus.
"You know stimulus is coming," said Vincent Reinhart, former director
of the Fed's monetary affairs division. "The appetite of a new
president and new Congress for a prolonged economic slump is zero."
The risk of deflation was among the factors leading the Fed to keep
interest rates at only 1% earlier this decade, when its preferred
inflation measure also was around 1%. The Fed's target rate now is
1.5% and some economists expect the central bank to lower it further
in coming months.
Fed policy makers can raise short-term interest rates to fight rising
prices, as they did into the early 1980s. But they can only cut rates
to zero to fight deflation. After that, other policy options come into
play.
Deflation concerns in 2002 and 2003 led Fed officials to consider
alternative measures to stimulate the economy. Their initial option
came from the Fed's 1940s playbook: buying Treasuries to force down
long-term yields, leading consumers and businesses to spend instead of
save. In normal circumstances, effectively pumping money into the
economy would support growth and spur inflation over time. Today's
credit crisis has pushed Treasury yields lower already as investors
seek less-risky assets.
Mr. Reinhart, among the officials leading the Fed's deflation studies
earlier this decade, said the Fed now has other tools. This month,
Congress gave the central bank permission to start paying interest on
reserves held by commercial banks. That gives the Fed more latitude to
expand its balance sheet, which it can use to pump more reserves into
the banking system.
In 2003, the Fed signaled its willingness to keep interest rates down
at 1% for a "considerable period." That communication helped support
the economy by pushing market rates down. Today, Fed officials are
facing criticism for keeping interest rates too low for too long this
decade, worsening the housing boom.
However, "if the economy is under duress," Mr. Reinhart says, "too
long doesn't look that long at all."