Reaction to the U.S. Federal Reserve’s recent expression of concern over the possibility of deflation in the world’s biggest economy has ranged from alarm to dismissal. But even the optimism of those who believe the U.S. is not headed for a period of generally falling prices may be dampened by much of the economic data that has followed the Fed’s historic statement.
The evidence of continued downward pressure on inflation has mounted since the Fed’s May 6 remarks, which accompanied its decision to leave the key fed funds rate unchanged at 1.25%, a 40-year low.
The U.S. consumer price index excluding food and energy slowed to 1.5% in April, its lowest rate of increase since January 1966. Wholesale prices as indicated by the producer price index in April dropped 1.9%, the biggest decline in more than 50 years. Even excluding food and energy, the PPI slid 0.9%, the biggest decline since 1993. Separately, April import prices fell 2.7%, the biggest drop in a decade.
Industrial production fell 0.5% in April, the same as in March, while Fed data showed U.S. output was 25.6% below its estimated potential, the biggest “gap” since June 1983. Retail sales unexpectedly contracted 0.1% in April.
Over the first quarter, commodity prices excluding food and energy declined by 1.4% from a 0.9% drop a year earlier, while inflation in the service sector has slowed to 3% from 4% over the same period.
In its statement, the Fed startled financial markets by saying that “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.” The balance of economic risks, it said, is “weighted toward weakness in the foreseeable future.”
Coming from a central bank whose overwhelming focus for decades has been the restraint of inflation, the signal that it may now be shifting its focus to stopping a fall in prices was remarkable. U.S. Treasury debt prices have soared in response to the official recognition that inflation is no longer the main threat, driving the yield on the 30-year bond to a record low of 4.44% on May 16.
“The Fed is saying that it is more worried about deflation than inflation right now,” says Marshall Blume, director of the Rodney L. White Center for Financial Research at Wharton. “The Fed is on the money.”
U.S. Consumers Vs. Japanese
The latest decline in import prices despite the current weakness of the dollar – which would normally be expected to boost import prices – is a bad sign for demand within the U.S. economy, Blume notes. And the declining producer price index could also signal a deflationary trend if it persists. “If the PPI falls again next month, I would be really worried.”
Unemployment is probably higher than its latest official level of 6%, Blume adds, because the Labor Department’s surveys don’t allow for people who have been out of work for more than a month and/or have given up looking. These people don’t show up in the statistics.
The demand-sapping effect of unemployment exacerbates a deflationary trend in which consumers defer spending because they expect prices to be lower in the future. That leads to employers laying off workers, creating a vicious cycle of falling demand and eventually creating overall economic contraction.
“It’s no wonder that the Federal Open Market Committee (FOMC) is worried about the possibility of an unacceptably low inflation rate, especially as oil prices have fallen almost 30% in the last two months,” wrote analysts at State Street, an economic commentator, in their weekly bulletin ending May 7. The so-called headline indexes, which include energy, are likely to decline in coming months because of falling oil prices, the report said, adding that “a near-term acceleration of growth, while certainly plausible, especially given further fiscal stimulus, remains much more a leap of faith than a near-term deceleration of inflation. The FOMC has got it right.”
But other economic signals paint a more encouraging picture, according to Ayako Yasuda, professor of finance at Wharton. Compared with Japan, where prices have been falling since 1995, the U.S. economy is in vigorous shape.
U.S. consumers are younger and more inclined to spend than their counterparts in Japan where an aging population and low consumer confidence conspire to restrain spending and hence hiring and production, Yasuda says. “A larger share of the population depends on their savings and that has put a tight lock on the consumer’s purse.”
In the U.S., the labor market is more mobile than Japan’s and labor laws make it easier to fire workers in response to declining demand. In addition, U.S. banks’ ability to lend isn’t as likely to be hurt by corporate failures because they are not, unlike their Japanese counterparts, allowed to own the stock of other corporations, Yasuda adds.
A more sanguine view of the economy is also contained in the Fed’s statement. In addition to the section on deflation, it contains comments about the positive effects of the ending of war in Iraq, the decline in oil prices, and rising debt and equity markets, all of which could be read as offsetting the deflation signal. Those developments, taken together with the current accommodative stance of monetary policy, “should foster an improving economic climate over time,” the two-paragraph statement said.
Since the statement, the Fed seems to have played down deflation fears. Vice chairman Roger Ferguson noted in a speech in St. Louis on May 16 that the possibility of deflation “remains quite remote” because of previous rate cuts, falling oil prices and declining business and consumer debt.
A Faltering European Economy
Carl Weinberg, chief economist at High Frequency Economics, a consultancy in Valhalla, N.Y., suggests that the Fed’s statement smacked of compromise between some members of the Federal Open Market Committee who see a deflation risk and those, perhaps including Chairman Alan Greenspan, who don’t. Greenspan made no reference to deflation in his testimony to Congress on April 30, Weinberg notes.
The majority of board members don’t support the view that deflation is a problem because if they did they would have cut interest rates, Weinberg adds. “If they really wanted to make an (unequivocal) statement about deflation, they would have done so. It was needlessly complex.”
Weinberg plays down fears of deflation, saying the traditional prescription for the condition – a general fall in wages at the same time as falling prices – is not being met, and that the full benefit of the Fed’s aggressive reduction in interest rates has not yet been felt.
But U.S. efforts to guard against deflation are complicated by a faltering economy in Europe, where policymakers are grappling with near-recessionary conditions. First-quarter output of the 12-nation euro area showed no growth compared with the previous three months and was only 0.8% higher than a year earlier. Germany, the eurozone’s biggest economy, said output shrank 0.2% after a marginal 0.03% decline in the previous quarter. That technically met the definition for recession of two consecutive quarters of economic contraction. The Dutch and Italian economies also contracted by unexpectedly large margins in the first three months.
Those figures follow a decision by the European Central Bank to redefine its inflation target in a recognition – some analysts say belated – that deflation may be at least as potent a threat as inflation. The ECB now aims to keep inflation “close to but below 2%” compared with its previous formulation of “at 2% or less.”
Europe’s economic problems have been exacerbated by the rise of the euro which has surged by about a quarter against the dollar in the last year, making it harder for European companies to sell their goods and services overseas.
Concern about U.S. deflation increases the pressure for Europe – where official interest rates are twice as high as those in the U.S. – to contribute more to global growth. U.S. Treasury Secretary John Snow called on May 15 for “multiple engines of growth” to revive the world economy.
Spend, Don’t Save
With the threat of deflation looming, and interest rates in many countries close to zero, fiscal and monetary authorities must consider a range of stimulative measures that reflect extraordinary times.
“The level of inflation is ultimately a political decision,” says Wharton’s Blume. “If the government decides it wants a higher inflation rate it can make it happen by pouring money in.”
That stimulus should come in the form of tax cuts for both companies and consumers that would be much larger than those currently proposed by the Bush administration, and would be made with a requirement that the proceeds be spent within a certain time frame so that the extra money doesn’t just find its way into savings accounts, says Blume. He declined to specify the total size of any such stimulus.
The resulting budget deficit would not be a problem as long as the debt was held within the country, Blume adds. “It’s like borrowing between family members – you might have a problem between them, but the family is no poorer.”
Any attempt by the Fed to boost business investment by buying long-dated Treasuries is unlikely to be effective; companies won’t invest in new plant and equipment just because long rates are a bit lower, Blume says. There are a host of other uncertainties that govern capital investment decisions. As for interest rates, any further cut from the current low level might help the housing market but is unlikely to provide a significant jump-start to the economy.
As in the Great Depression, policymakers should consider public works programs to stimulate employment but should avoid “building bridges to nowhere,” as has happened in Japan’s recent efforts to kick-start its economy, Blume says. “Japan has tried it by doing public works projects, but if they have no value to the economy it’s not going to improve things.”
The Fed’s surprising, some say seismic, statement on deflation is the first glimpse of official thinking on the issue, and signals that preparations are being made in the Treasury and elsewhere in the federal government, Blume suggests. “The wheels are turning all over the place.”