Recent data show that the U.S. economy has lost momentum. As a consequence, the debate within the Federal Reserve is intensifying over the best way to prevent a double dip into a recession, coupled with deflation — a widespread and prolonged drop in wages, the prices of goods, and the values of homes and stocks.
Policymakers are weighing whether the decline in annual growth rates in the second quarter 2010 to 2.4% requires further government intervention. Government reports reveal that consumers remain skittish about the economy’s prospects. Their confidence is essential to growth because individuals represent about 70 percent of economic activity.
Fed Chairman Ben Bernanke has yet to endorse precise policy steps to counter the twin threats of a waning economy and deflation.
On Monday, Bernanke said monetary policy should remain “loose” until sustained growth is seen in jobs. He also noted that the Fed must be careful not to raise interest rates too soon and the government should proceed cautiously in cutting spending and raising taxes.
Recently, a few Democratic Senators have supported not raising taxes even on Americans earning more than $250,000 per year.
Last week, James Bullard, president of the St. Louis Federal Reserve, released a report, “Seven Faces of ‘The Peril.'” Three other Fed Bank presidents, Eric Rosengren of Boston, Janet Yellen of San Francisco and William Dudley of New York agree with Bullard about the threat of deflation.
Bullard’s main conclusions:
The Fed’s commitment to leave rates low for an extended period may increase the probability of a Japanese-style recession outcome for the United States. Japan suffered from deflation and a recession from 1988 to 2006.
Instead, Bullard says the Federal Reserve should purchase U.S. Treasury debt in order to energize the economy and nip deflationary forces. Fed purchasing of government securities raises the reserves of the banking system and reduces banks’ overnight borrowing costs.
Raising reserves encourages banks to make more loans.
Why does Bullard think the Fed policy of keeping interest rates low for a long time is counterproductive? Low rates signal that the Fed leaders expect the inflation rate to keep falling. The expectation of on-going declining prices makes it more likely that the economy falls into the deflation trap.
Bullard pointed out that inflation is running at only 1 percent, some 50 percent below the Fed’s unofficial target. America’s continued economic malaise will drag down prices and wages further.
Bullard’s new concern about deflation is noteworthy because, until now, he had been more worried about the potential inflationary effects of Fed asset purchases rather than deflation.
Why is deflation bad?
Deflation leads to a phenomenon called the “liquidity trap.” The “liquidity trap” refers to postponed spending because people expect lower prices in the future. When people spend less, businesses must fire employees and take other measures to reduce overhead. Higher unemployment in turn lowers the overall saving rate in the community and reduces consumption.
To stop this vicious cycle, economist John Maynard Keynes advocated massive government spending to overcome insufficient private spending. But the current widespread concerns about the deficit makes another round of stimulus spending unlikely.
At the next Fed meeting, on Tuesday, the Fed might institute some or all of the following steps to promote economic growth and reduce the likelihood of deflation:
Cut to zero the interest rate paid on money that banks park at the Fed. Paying zero would force the banks to make more loans because they can no longer earn money from deposits at the Fed.
Provide more information on how long they will keep interest rates at record lows.
Follow Bullard’s prescription and buy more mortgage securities or government debt.
Originally published in the Sarasota Herald-Tribune
