Deflation Formation

After more than a year into the rate cut cycle, the Federal Reserve announced that it was cutting short-term interest rates again yesterday. The US central bank pushed its benchmark federal funds rate down half a percentage point to 1% and signaled that more rate cuts are a possibility, noting that "downside risks to growth remain." Joining the Fed in the action was China, which cut rates for the third time in six weeks, amid a worsening growth outlook for its export-dependent economy and Norway, which cut its benchmark interest rate for the second time in two weeks. The European Central Bank and the Bank of England are expected to follow next week and Japanese authorities signaled they too might cut rates from ½ point to ¼ point.

Now that US rates are at levels not seen since 2002, fears are re-emerging that deflation will haunt the economy and keep us buried in a stagnant state for years to come. Simply stated, deflation occurs when consumer prices fall broadly. The problem with deflation is that it can lead to a vicious cycle: falling prices diminish corporate profits, which can lead corporations to reduce headcount. When consumers are worried about the job market, they are less likely to spend, which hurts profits once again. The most recent example of deflation was seen in Japan in the 1990’s. After that country’s real estate and stock market boom and bust, its economy ground to a halt. While the Japanese central bank lowered interest rates to zero and held the rate there, the economy still did not respond. In fact, only when officials there recapitalized banks, did the economy revive.
According to a number of analysts, the chances that the US will avoid deflation are pretty good. The primary reason is that the Fed is on the case much more aggressively than the central bank in Japan was. In addition to cutting short-term rates, the Fed has an arsenal ready to deploy in order to fight potential deflation. It can conduct operations to bring Treasury or private securities’ rates down, they can finance fiscal stimulus and they can undertake “quantitative easing” of monetary policy, which simply means that the central bank floods the system with liquidity. So while it is true that the Fed can only cut short term rates to zero, it is not constrained in how much it can increase its own balance sheet by making loans or acquiring assets. It can create new bank reserves at will and use those reserves to make loans itself or take on distressed assets.

Other reasons to believe that deflation may not be coming on the horizon include: while home and commodity prices are in fact falling, the current decline represents a reversal of the major spike that occurred leading up to this time; companies will quickly cut capacity to balance supply and demand; and some of the emerging global declines in goods prices are declines in relative prices, not prices generally. This is not to say that the credit crunch is not deflationary in nature or that prices are not coming down. Nor does this line of reasoning rule out the idea that deflation could envelop the US economy, but at this stage, it seems less likely to occur in the near term.