Alarm bells ring at Fed (deflation alert)

It was a conference to mark Milton Friedman's 90th birthday last month, and who should give the toast to the world's most famous monetarist? A governor from the US Federal Reserve, naturally.

The man from the Fed, a monetary expert in his own right, Ben Bernanke, delivered a dense, 10-page tribute to Friedman's contribution to modern economics, then this punchline: "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton ... regarding the Great Depression: You're right, we did it.

A couple of weeks later, seemingly following through on this pledge, Bernanke delivered an unprecedented speech in Washington DC. The title: "Deflation: Making sure it doesn't happen here."

It was the Fed's emergency plan, the economic equivalent of the The Worst-Case Scenario Survival Handbook

Bernanke laid out the extraordinary measures the Fed could take - including buying assets from private companies - if the US economy fell into that condition people associate most closely with the Great Depression - deflation, a fall in the general level of prices, the opposite of inflation.

If inflation is too much money chasing too few goods, then deflation is too little money chasing too many goods.

Fed chairman Alan Greenspan told anxious members of Congress in October that "we are not close to the deflationary cliff". But how good are his forecasting skills? The Fed, by its own admission, utterly failed to foresee Japan's slide into deflation seven years ago.

And a solid core of serious analysts now believes it to be a very real risk. The Fed's own behaviour betrays a distinct unease. A month ago it cut the key official interest rate by an aggressively large increment - from 1.75 per cent, already the lowest in over 40 years, to 1.25 per cent.

Fed officials have called that move insurance. Although the financial markets think there is little chance that the Fed will cut rates again at its policy meeting this week, "the Fed is, I won't say panicked", says Steve Roach, economist for the investment bank Morgan Stanley, "but it is very much on alert".

The decision by President George Bush to replace his economic team last week is another indicator that American officialdom is alert to the need for decisive action to keep the economy from quicksand.

As the Fed's Bernanke says: "Sustained deflation can be highly destructive to a modern economy and should be strongly resisted."

The broadest measure of price pressures in the US economy - the gross domestic product deflator - is barely above zero. In the year to the end of September, it was up by 0.83 per cent, its feeblest in half a century.

"The essence of deflation is that business leaders know they do not have pricing power," the ability to raise the price of their products, points out Wayne Angell, a former governor of the Fed and chief economist for the Wall Street investment bank Bear Stearns.

And the prices received by US firms overall have declined in each of the past five quarters, the longest run in more than 50 years. For the latest quarter, they were down 1.3 per cent.

At first, and sometimes for years, executives think that this lack of pricing power is temporary, due to a downturn in the business cycle, Angell says.

"They expect that pricing power will return with recovery." With deflation, it doesn't. "This is precisely what is happening in the US economy today."

Consumer prices in the US are still rising - by 1 to 2 per cent a year, depending on the measure. But David Rosenberg, an economist in the Canadian office of the US investment bank Merrill Lynch, points out that the price of 40 per cent of the hundreds of items that go into the basket to make up the consumer price index are falling.

Indeed, all the inflation in US consumer prices is coming from only five areas that make up a quarter of the index - housing, tobacco, car insurance premiums, hospital services and tuition.

"There's a compelling case for deflation," says Morgan Stanley's Roach. "We are in a rarefied and highly dangerous period."

The two top-most international finance officials in Japan last week took the warning even further. They declared that it was not just a danger facing the US - it was a risk to the entire world economy.

In an unorthodox move, the Vice-Minister for International Affairs at Japan's Ministry of Finance, Haruhiko Kuroda, and his deputy, Masahiro Kawai, put their case starkly.

"Monetary policymakers around the word are still fighting the old enemy of inflation, not the new foe of deflation," they wrote in the Financial Times.

"There is an urgent need to switch to global reflation in order to avoid a deflationary spiral." They called on the Europeans, Americans and Chinese to join Tokyo in heading off a global deflation. And the Japanese know something about contemporary deflation - they pioneered it.

The mainstream of US forecasters does not foresee deflation in the US. But then again, the mainstream does not have such an enviable record of forecasting - the consensus of US economists conspicuously failed to foresee the length of America's boom of the 1990s, and completely missed its 2000 bust.

What of Milton Friedman's school, the monetarists, whose believe that the supply of money is the key to inflation and deflation?

A respected US monetarist, Allan Meltzer, professor of political economy at Carnegie Mellon University and author of a new book, A History of the Federal Reserve, dismisses the possibility of deflation as nonsense.

"It's just bad thinking by badly trained Wall Street economists," Meltzer says. "I don't think any competent economist can make the case for deflation with M2 [the base money supply] growing at 8 per cent year on year and the economy expanding.

"You hear it from that Morgan Stanley guy, and his policy is being able to say, if something goes wrong, 'See, I told you so!', and he hopes that people forget the 800 times he was wrong."

"I don't want to call a guy like Allan Meltzer simplistic ... but he's pretty consistent with his monetarist framework.

"With all due respect to him, the money supply may be growing, but there's no guarantee that it will go into consumption or prices. It's a circuitous route, at best - especially in an overindebted economy.

"Money can go into debt or saving; if you print enough of the stuff it will eventually spill over, but it's a long and arduous path."

It should also be pointed out that Roach's forecasting record is quite good, and better than most.

But even if you disbelieve the case for deflation, the most persuasive case for vigilance comes from the Fed itself.

An important research paper by 13 Fed staff economists, titled Preventing Deflation: Lessons from Japan's Experience in the 1990s, says: "Japan's deflationary slump was not anticipated. This was true not only of the Japanese policymakers themselves, but also of private-sector and foreign observers, including Federal Reserve staff economists.

"Moreover, financial markets had no better handle on the economy's prospects ... The failure of economists and financial markets to forecast Japan's deflationary slump in the early 1990s poses a cautionary note for other policymakers in similar circumstances: deflation can be very difficult to predict in advance.

"In consequence, as interest rates and inflation rates move closer to zero, monetary policy perhaps should respond ... to the special downside risks - in particular, the possibility of deflation."

Deflation is not necessarily a bad thing. The world economy has enjoyed booms while prices were falling, during the 1920s, for example.

But it looks malign at the moment for two main reasons. First, there is a kind of good deflation that happens when productivity is high and the economy is robust. This is not that kind of deflation. Today's deflationary pressures come from excess supply of goods and industrial capacity.

Second, deflation is especially dangerous now because the US has unprecedented proportions of debt. Why does this matter?

In an inflation, money loses value, so the inflation-adjusted value of debt shrinks as the years go by. So inflation is kind to borrowers.

But in a deflation, the opposite holds. Because prices are falling, the real value of money goes up in a deflation. So the value of debt actually rises, and borrowers are punished.

This can create a debt trap, forcing firms and families into a spiral of cutbacks to service a growing burden of debt - even though they're not borrowing a cent more. This pattern of retrenchment and bankruptcy can create recession and depression.

"We've already got debt deflation stories - we do have quite a large number of firms that are facing those kinds of pressures from unexpected sort of deflation already," says former Fed governor and leading forecaster Larry Meyer.

"And, as slack builds up in the economy, we're likely to see inflation fall below the implicit target" of the Federal Reserve, says Meyer.

"And, we know in those situations, again, following the lessons of Japan, that the policy authorities have to be particularly even more aggressive about pushing inflation back [up] to its target."

The Fed's contingency plan includes drastic options. If the key official interest rate should hit zero and the Fed loses its ability to stimulate the economy in the customary way - the current rate is already at 1.25 per cent - it could

buy up masses of government debt, even private corporate debt and private real estate, as a way of pumping liquidity into the economy. Fed governor Bernanke also points out that big devaluations of the US dollar have helped defeat deflation in the past.

Ultimately, "the US government has a technology, called a printing press ... that allows it to produce as many US dollars as it wishes at essentially no cost ... Sufficient injections of money will always reverse a deflation", he says.

Morgan Stanley's Roach says that the Fed's speech and its actions "are all very carefully orchestrated; they are shaping policies as if deflation is going to happen - and that's a good thing, because it is such a dangerous time".

The problem with your scenario is that you presume that people will continue to trade a commodity that has more use value than exchange value. What do we do when everyone has enough guns and bullets? Or they can't store them? transport them? divide them? Or even better: what happens when I learn to produce them myself, thus basically being able to counterfeit? The fact is that the MARKET determines what is and what is not money. It does this by determining which good is the most marketable over the others. Historically, its been a metal: gold or silver.

I agree with most of what you said but one point is not right. In a deflation the velocity of circulation does not increase, it falls, and in an inflation the velocity increases. When inflation is in swing you want to hold money as short a time as possible. With deflation you want to hold it as long as possible since it is becoming more valuable.

Why do you think the Gold Standard has been rejected by every advanced nation? Why do you think it was NEVER truly in operation for more than a few yrs. at a time? Hint: because there never was enough money when a country adopts it since the supply of gold cannot grow fast enough to allow economic growth. It is a mere supersition and does not prevent inflation in any case.

The Fed is perfectly constitutional Article I Section 8 gives Congress the authority to control the money supply. Hamilton (as much responsible for the Constitution as any man and as knowledgable about it) destroyed the unconstitutionality argument with his essay on the National Bank. You should read it before declaring such things.

If fiat is destroyed you won't be dancing in the streets but you may very well be running for your life.

Yawn. I live in a cabin in the Rockies. Its about 200 feet up a cliff face. I can put holes in anything or anyone within 1000 meters.

Fiat is evil and needs to die for the good of the country.

That was tried early in the 1800s. It produced massive fraud and economic disaster. The greatest depression in U.S. history until the 30s resulted from destroying the National Bank II.

Fiat is a misnomer in any case. Look at Germany in 1923. The government said "fiat" the people said "phooey."

That was tried early in the 1800s. It produced massive fraud and economic disaster. The greatest depression in U.S. history until the 30s resulted from destroying the National Bank II.

What was tried?

The reason those interventions occured was because of chronic shortage of money outside of the money centers. This is endemic to the "gold standard." All are ditched as soon as war erupts. Gold supplies are too limited to allow prosperity on a worldwide scale. A money supply dependent upon luck for sufficient quantities is not rational.

Private banks creating their own money supplies. Wildcat banks they were called. Some were credible but most just printed as much money as they wanted. When the bills came back the bank owners had amscrayed with the gold allegedly backing them.

Much harder to amscray these days and its much easier to maintain transparency. Our current system privatizes profit while socializing risk. A receipe for disaster. ANY system will work so long as responsibility and power are in proportion. Alternatives to dollars are and should be emerging. The more alternatives, the better in my mind. Rather than offering an example of a system that failed in the past (true of democracy,flight,heart surgery,etc,etc) a more powerful argument would be based on an analysis of the failure mechanism, in your example simple theft and rampant inflation. This is NOT an strong argument to nationalize theft and inflation.

"Gun free" LoL. Guess you don't know much about Chicago. Have no fear my neighborhood is perfectly safe and will remain so.

Good to hear...but it seems the city has almost purposely built in a self destruct device...I prefer the woods.

There is nothing which maximized private profit while socializing risk any more than the Wildcatters. They helped write the book.

Really, when they failed were innocent uninvolved bystanders forced to bail them out?

There are and always have been alternatives to dollars. And always will be.

Well, I wish they would stop taxing wealth preservation. Wealth preservation is not a "capital gain".

New cars, new or better computers are not. It's not TV's or DVD's. It's not more vacations.

I agree. I think 911 still has a lot to do with it. I know that I personally think it is more important than ever to pay down my debt and get financially secure, to the extent that that's possible. And I HAVE a new car, my old computer still surfs the net just fine, and I moved to a less expensive (and smaller) apartment to help pay down debt. I could care less about cable TV, broadband internet access, making long distance calls. I will probably cancel my cell phone soon because I don't really need it. I take short vacations by car since I don't wish to be strip-searched at the airport, and I visit and stay with family.

I am becoming a cloth-coat republican and I'd venture a guess that there are a lot of us on this site. I voted a straight republican ticket for the first time this time and helped the Republicans make their unprecedented gains.

I sense that in many ways I am everyman.

Cities have always been the engine of civilization. In fact, the words are etimologically related.

True but the reasons for that are becoming increasingly obselete. The idea, of course, is to create crown fires of capital and intellect while enjoying the benefits of shared resources.

Today, I design anti-missle laser systems on my laptop in the woods. Almost any publication is available at the click of a mouse, and I can chat with colleagues anywhere in the world from my deck.

Having lived in the southern pines until finishing high school, I am very familiar with the woods. Nothing would convince me to go back.

Having lived with the stench of used wine in downtown Atlanta for many years, I have no desire to go back either.

"In a deflation the velocity of circulation does not increase, it falls, and in an inflation the velocity increases."

So when a store lowers its prices (i.e. localized deflation) sales decrease? And when a store increases prices (localized inflation) sales speed up?!

I don't think so.

"Alternatives to dollars are and should be emerging."

The great thing about the Dollar is that you can buy anything with it.

If you want to store your wealth in gold, then you can use Dollars to purchase gold.

If you want land, then the Dollar already buys that, too.

So I don't see the reason to clamor for a mandatory currency replacement. Why force everyone to change to a "new" form of currency away from the Dollar? People can already get whatever they want, so where is the big advantage to compelling everyone to undergo an expensive change? What would we gain?

Is there any possible currency that will be MORE flexible than the Dollar? Is there any possible currency than can insure that EVERY conceivable liquidity demand in our entire economy is always met? Are there any limitations to what the Dollar can currently buy that another currency would remedy?

If so, I certainly don't see it.

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