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How the Fed's Deflation Phobia Buoyed the Markets

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.