The D-Word

For some time now, the US economy has had all the ingredients—soft, anemic labour markets and wage growth, slack consumer demand, a real estate sector that has to revive after a three year downturn—for a deflationary cycle. Deflation was last seen in the US in the 1930s and in Japan in the 1990s, when the inflation rate fell to zero and then turned negative for several years. But now the Federal Reserve is increasingly concerned that we may be on the cusp of a deflationary asset spiral.

From the New York Times:

On Thursday, James Bullard, the president of the Federal Reserve Bank of St. Louis, warned that the Fed’s current policies were putting the American economy at risk of becoming “enmeshed in a Japanese-style deflationary outcome within the next several years.”

The warning by Mr. Bullard, who is a voting member of the Fed committee that determines interest rates, comes days after Ben S. Bernanke, the Fed chairman, said the central bank was prepared to do more to stimulate the economy if needed, though it had no immediate plans to do so.

Mr. Bullard had been viewed as a centrist and associated with the camp that sees inflation, the Fed’s traditional enemy, as a greater threat than deflation.

But with inflation now very low, about half of the Fed’s unofficial target of 2 percent, and with the European debt crisis having roiled the markets, even self-described inflation hawks like Mr. Bullard have gotten worried that growth has slowed so much that the economy is at risk of a dangerous cycle of falling prices and wages.

Among those seen as already sympathetic to the view that the damage from long-term unemployment and the threat of deflation are among the greatest challenges facing the economy, are three other Fed bank presidents: Eric S. Rosengren of Boston, Janet L. Yellen of San Francisco and William C. Dudley of New York.

Deflation is a particularly vexing economic problem because as prices fall, people who already owe money have to pay back loans in dollars that will buy more goods than the dollars they borrowed. Assets are worth less than the amount owed. For new loans, it raises the real, or inflation-adjusted, cost of credit, the opposite of what monetary policy needs to do to combat falling demand. Plus, in the effort to boost spending, policymakers cannot cut the target rate below zero. At that point, negative inflation can keep the real rate high enough to restrict economic growth.

Here's a recent note from the Federal Reserve Bank of San Francisco on the Risks of Deflation.

Tags: US Economy, US Labor Markets, Federal Reserve, deflation (all tags)

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