Archive for Sunday, December 1, 2002

Fed still has ways to prevent deflation

December 1, 2002


The Federal Reserve has cut short-term interest rates to their lowest levels in four decades, and still the economy is just dragging. With the federal funds rate at 1.25 percent, down from 6.5 percent in January 2001, it looks like the Fed arsenal is nearly empty.

Would the Fed be helpless if the economy slipped back into recession?

Maybe not.

Fed Governor Ben Bernake, a Princeton economist who joined the board in August, outlined a series of unusual tricks the Fed could pull out of its sleeve to stimulate the economy and combat the threat of deflation - a destructive across-the-board decline in prices.

While his recent speech, to the National Economists Club in Washington, was somewhat reassuring, it also served as a reminder that no assumption about the future is a sure thing.

Think mortgage rates can never get much lower than today's remarkable figures? Perhaps they can. Think your ever-more-valuable house is a big rainy day fund? Maybe it's not. Like the idea that inflation is whipped and prices could actually go down? Well, be careful what you wish for - deflation can be deadly.

Depression-like economy

Anyone who has shopped for computers has a sense of what deflation does to consumer decision-making: You want a new computer now, but if you just wait a few months the same machine is sure to cost hundreds less, so you hold off.

Deflation might be great if your income stayed the same, but it probably wouldn't. If you worked for a manufacturer or service company, falling prices could turn profits into losses. The boss would have to fire workers or cut wages. Though each dollar would buy more as prices fell, that wouldn't be much help if you had fewer dollars.

Americans' falling spending levels would drive prices down even further, creating the kind of spiral Americans experienced during the Depression years of 1930-1933, when prices fell 10 percent a year.

With deflation, interest rates would gradually fall to zero. Sounds great, but you'd be crazy to take out a new loan because you'd have a harder and harder time making payments as your income dropped.

People who took out loans before deflation hit would find that problem unavoidable. Rising numbers of defaults could cause banks to fail, just as they did in the '30s :quot; or as many Japanese banks have done as that country experienced deflation in recent years.

Inflation has been in the low-single digits for years, which means we're not that far from a deflationary condition now. Still, not many economists think deflation is imminent.

But many are concerned that, after cutting short-term rates to 40-year lows, the Fed can't do much more to stimulate the economy.

Sure it can, says Bernake: If cutting short-term rates doesn't work, it could attack intermediate- and long-term rates.

Fed's other means

Traditionally, the Fed spurs or slows the economy by tinkering with the federal funds rate charged for overnight loans banks make to one another. Making money more freely available allows businesses and consumers to spend more.

The Fed does not have the same direct control over longer-term rates :quot; such as those that guide things like car loans and mortgages. These are governed by supply and demand as investors buy and sell bonds among themselves. If demand pushes bond prices up, interest rates fall.

If things got very bad, the Fed could print money, then use it to buy Treasury bonds back from investors, Bernanke said. The purchases would pump money into the economy in the same way the Fed does when it lowers short-term rates. By bidding up prices for bonds, the Fed could drive down intermediate- and long-term interest rates.

Imagine a $1,000 bond that pays its owner $50 a year, or 5 percent. It pays $50 regardless of what supply and demand do to the market price of the bond. If the Fed drove the price to, say, $1,200, that $50 would be an interest rate, or yield, of about 4.2 percent - $50/$1,200.

Other rates, such as those on mortgages, would move down as the marketplace adjusted.

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply," Bernanke said. "But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

"By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government also can reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

A second way to drag down longer-term rates, he said, would be for the Fed to announce it would keep short-term rates low for a fixed number of years. This would work because longer-term rates are influenced by investors' speculation about what short-term rates will be in the future, he said.

All seems plausible to me. But what's the risk all this will be needed - that we will, in fact, tumble into deflation?

Bernanke said the U.S. economy is probably resilient enough to recover without such extreme measures. And the very fact that the Fed has these weapons in reserve may help provide the marketplace with the reassurance it needs to avoid another deep downturn.

The fact is, deflation is pretty rare. One reason is that so many market forces are pushing the other way - workers press for raises and companies constantly try to raise prices. Most people understand that a small amount of inflation is good. Your house gets more valuable while your salary goes up, making mortgage payments easier to meet, for example.

But if the threat of deflation is worthy of the Fed's attention, the rest of us should be hedging our bets, too - by keeping debts low and saving for a rainy day.

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