Commentary: If Deflation Sets In, the Fed Has a Problem

Federal Reserve Chairman Alan Greenspan and his central bank colleagues will tell you that the danger of deflation is no big deal. In the remote event that the U.S. dives into a deflationary spiral, policymakers say, the Fed has all the tools required to turn things around. "Sufficient injections of money will ultimately always reverse a deflation," Fed Governor Ben S. Bernanke asserted confidently last fall.

Let's hope he's right, because deflation is not out of the question. Excluding volatile food and energy costs, consumer prices rose 1.9% last year, the smallest increase since 1965. It wouldn't take much to turn that number negative. "We're in dangerous territory," says former Fed Vice-Chairman Alan S. Blinder, now an economics professor at Princeton University. "When you've got inflation as low as we've got it, one good-sized recession is enough to bring it down to zero, or even maybe below zero."

A downward price spiral may not be quite as easy to whip as Fed policymakers let on. They acknowledge that cutting short-term interest rates won't work in a deflationary downturn because the rates can't drop below zero. But they argue that the central bank could take unconventional measures--such as flooding the banking system with money, buying up Treasury bonds, or selling off the dollar--to revive the economy and break the back of deflation.

All those tools, however, are untested as counterdeflationary strategies. "We don't know that any of them will work," says Janet L. Yellen, a former Fed governor now teaching economics at the University of California at Berkeley. Indeed, staffers at the Fed's own board concluded two years ago that the efficacy of such measures was "uncertain."

Let's say the Fed starts pumping a lot more money into the financial system by significantly stepping up its purchases of Treasury bills. If banks were already awash with cash and short-term interest rates were at zero, that added Fed largesse wouldn't make much difference to the economy.

That's why Greenspan and Bernanke have suggested that the Fed could extend its market operations to buying up longer-dated Treasury securities. That could help the economy by bringing down long-term rates. In defending such a strategy, policymakers point to the Fed's success in holding down long-term rates to help finance the U.S. military machine during World War II. But when the Fed tried again to manipulate long-term rates in 1961 in a maneuver called Operation Twist, it had little success. That may have been because the size of its dealings in the market then weren't that big.

Even if the Fed did lower yields on Treasury bonds via a massive incursion into the market, there's no guarantee that homeowners and corporate CFOs would be rewarded with lower borrowing costs. In normal times, mortgage rates and corporate bond yields do tend to rise and fall in tandem with Treasuries. But deflation is anything but normal. With prices of assets as well as goods and services falling, fears of default might prompt lenders to keep rates up for homeowners and companies, even if Treasury yields fell sharply.

Instead of trying to help the economy through lower long-term interest rates, the Fed could attempt to fight deflation by buying up foreign currencies. The move would be designed to drive down the dollar in order to make foreign imports more costly in the U.S. and American products more competitive abroad. But the record of central bank intervention in the currency market is spotty at best. Then there's the risk of setting off a trade war and tit-for-tat currency devaluations.

So why are Fed policymakers talking so bravely about their ability to reverse falling prices? It's a confidence game. If consumers and companies believe the Fed is powerless to combat deflation, the battle is lost before it's begun. Better that they give the Fed the benefit of the doubt. Defeating deflation--should the scourge materialize--will be hard enough as it is.

By Rich Miller

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