Saturday, October 18, 2008

Threat of Deflatoin Looms - WSJ

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." Reuters Falling prices in commodity markets have helped ease inflation. 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. More Real Time Economics: Bernanke and the Famous HelicopterMr. 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."

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