The Federal Reserve recently acknowledged that the risk of deflation in the US, though still small, has grown. Is policy correctly aligned to confront this risk? Not yet.
With Japan as an example, nobody should need reminding that deflation is a uniquely dangerous prospect - but here is a refresher. Persistently falling prices increase the inflation-adjusted burden of debt. Insupportable debts are the core of the US economy's difficulties. If that burden grows even heavier because of falling prices, the contractionary forces will strengthen. The economy will slow further, the deflationary pressure will increase again, debts will become more burdensome, and so on. Since interest rates cannot fall to less than zero, monetary policy cannot follow inflation all the way down. This makes the deflationary circle difficult to break. Nothing is more important than preventing the economy from toppling into it.
Prices in the US fell in October by 1 per cent, the biggest such fall for 60 years. That was an urgent warning - though it does not mean that deflation has arrived just yet. Prices (excluding food and energy) are 2.2 per cent higher than a year ago. Expectations of inflation remain positive, which is crucial since expectations of inflation tend to be self-fulfilling. It would take a stunning and prolonged recession to drive inflation expectations negative, thus pushing the economy all the way over the deflationary edge. But a stunning and prolonged recession may be exactly what the US faces. At the moment, each new economic indicator shows a shocking rate of contraction.
This article available online at:
http://www.theatlantic.com/business/archive/2008/12/bernanke-and-the-risk-of-deflation/9137/
