Ever since the Federal Reserve signaled on May 6 that it was worried about deflation, many economists and business execs have been shaking their heads in puzzlement. With the dollar falling and tax cuts coming, deflation -- a broad drop in prices that's often symptomatic of economic malaise -- seems the last thing the central bank need worry about. "It's nonsense," says Allan H. Meltzer, a Carnegie Mellon University economics professor and author of a recent history of the Fed.

Nonsense or not, it certainly made the financial markets take notice. Since the Fed's announcement, long-term interest rates have plunged as investors have concluded a deflation-phobic Fed won't tighten credit anytime soon. The yield on the key 10-year Treasury bond dropped to a 45-year low of 3.51% on May 14. Expectations of continued easy credit have buoyed the stock market and knocked down the dollar, boosting prospects for U.S. exporters. Intentionally or not, the Fed's comments gave both the markets and the economy a welcome boost.

Which is all the more interesting, given that no one at the Fed thinks there's a big chance that the U.S. economy will suffer deflation. In their statement on May 6, Fed policymakers called the probability "minor." The problem is that if deflation hits, watch out. Should prices and incomes start falling, the economy could collapse, and the banking system could seize up. What's more, the Fed's usual policy tool for combating downturns would be less effective. Typically, the Fed battles recession by driving short-term interest rates below the level of inflation to spur borrowing. But it can't do that if prices are falling. In fact, the Fed has very little knowledge about or experience with reversing deflation.

That's why Fed officials figure they're better off overreacting than underreacting to even a hint of a deflationary threat. The steady erosion of inflation is of particular concern to Fed Governor Ben S. Bernanke, who wants the central bank to establish and publish inflation targets. Fed officials say he has raised the possibility of further rate cuts as "deflation insurance." Chairman Alan Greenspan still hopes the economy will pick up steam. For him, the concern is not so much falling prices, per se. As he suggested in Congressional testimony on Apr. 30, what's important is the interplay between prices and profit margins and the impact that has on capital spending.

If prices were to fall yet profit margins rise thanks to increasing productivity, that would be fine, just as it was for the high-tech industry during the '90s boom. But if both were to fall, that would discourage capital spending and risk-taking, two keys to the success of the New Economy for Greenspan. He's bound to be encouraged by the rally in junk bonds, which signals a willingness to commit to riskier projects.

So how would Fed policymakers stave off incipient deflation? In a speech to economists on Mar. 25, senior Fed official Vincent Reinhart suggested that the Fed could fight deflation by promising to keep short-term interest rates superlow until inflation returned. That could spark a rally in the bond market and drive down long-term interest rates. Sounds a bit like what the Fed did on May 6, doesn't it? Consider it a preemptive strike.

By Rich Miller in Washington

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