Fed Facing Deflation?

11/21/2008 11:33 am EST

Focus: MARKETS

Knight Kiplinger

Editor-in-Chief, The Kiplinger Letter, Kiplinger's Personal Finance, and Kiplinger.com

Knight Kiplinger, editor-in-chief of The Kiplinger Letter, sees deflation as a potential threat.

Just a few months ago, inflation worries engaged the Federal Reserve and its chairman, Ben Bernanke. But ever since the weakening economy hit a brick wall, concern has been shifting to warding off the threat of deflation.

Deflation is a tough enemy. Though it’s relatively rare in modern times, history shows that once deflation does take hold, asset prices continue to spiral down and stay low for an extended period. Consumers sharply rein in spending, expecting to pay less for goods tomorrow or at a later date. Businesses see profits slashed, so they are forced to cut back. Unemployment accelerates, and the downward slide continues.

Global deflation isn't a major threat yet, but the steep decline in prices for crude oil and other commodities, and the rapid and large drop in consumer spending in the third quarter, has escalated concerns.

The problem is that the Fed's primary tools are less effective against deflation than they are against inflation. Interest rates can go up as much as needed to blunt rising prices, such as when the benchmark federal funds rate—the rate banks charge each other for overnight loans—hit 19% in 1980 and 1981. But officials can't lower the nominal rate below zero.

We expect the federal funds rate to be cut from 1% to 0.5% by early 2009. Taking it lower would squeeze money market funds, which need a fed funds rate of at least 0.5% to cover their administrative expenses. Such a squeeze could hurt the money funds' ability to purchase commercial paper, the short-term IOUs that businesses sell in order to meet short-run cash flow needs, such as financing payrolls and inventory.

Central bankers do have other tools besides interest rates in their toolbox. The Fed has shown innovation in the past few months—purchasing top-rated commercial paper, accepting mortgage debt as collateral for loans, increasing deposit insurance at banks, expanding insurance to cover money market mutual fund deposits, and so on. In fact, the Fed has expanded holdings of assets to about $1.6 trillion, up from about $800 billion just a month or so ago.

Still, Bernanke doesn’t want to rely solely on the Fed to fix this economy. Sensing that monetary policy by itself can't turn around an economy beset by falling prices and a dearth of lending and spending, the Fed chairman has urged Congress to pass another round of fiscal stimulus. And the Democrats, led by president-elect Barack Obama, appear eager to deliver.

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