"The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation."
This is the key phrase in the brief statement issued by Alan Greenspan and the Federal Reserve's monetary gurus Tuesday after their meeting to discuss interest rates. Greenspan and the central bank's Federal Open Market Committee fear deflation in the U.S. economy. The fact that the Fed is taking the risk of deflation seriously may itself shake Wall Street which, through the traumas of the past three years, has, for the most part, continued to trumpet an astonishingly bullish line.
What is deflation and why is it bad? Deflation means that price indices are falling, so that not just the prices of a car or a computer are falling, which most of us would find a good thing, but the overall consumer price index. That puts generalized strain on company profits and pushes companies to want to reduce one of their key prices, the price of labor.
In other words, in a deflationary environment, companies and even the government might seek to cut wages. This, in fact, happened in Argentina in recent years when an overvalued currency and recession brought about deflation and recession. Japan, with is very low inflation rate, growth and interest rates but chronic weak growth has generally been seen as suffering deflation in the past decade.
It is weakness in the U.S. economy that is creating the deflationary threat that the Fed is now taking more and more seriously. The Fed's statement said that "the balance of risks...is weighted toward weakness over the foreseeable future." Thus, after expressing agnosticism on future economic prospects because of the Iraq war, the Fed concluded this time that "recent readings on production and employment, though mostly reflecting decisions made before the conclusion of hostilities, have proven disappointing."
How seriously should we take the Fed's deflationary fears?
The arguments against any threat of deflation are essentially these. First, it can be said that, with the Iraq war over, the U.S. economy is poised to start growing again. That is the line of most U.S. financial market economists.
Secondly, the U.S. inflation rate is currently at a far from deflationary 3 percent. Thirdly, the U.S. dollar is tumbling, especially against the euro, which will tend to raise the prices of some imported goods. But the fact that imports are a relatively low share of U.S. gross domestic product, at 13.8 percent of GDP in 2002, and that a key import price, that of oil, is falling, will tend to mitigate the impact of higher import prices.
But what above all precipitates deflation is economic weakness and declining demand for products, services and labor. These risks are real in the United States today.
With the Federal Reserve's benchmark interest rate at just 1.25 percent and with the federal government pursing an expansionary cut tax and spend fiscal policy, U.S. economic growth is barely positive, recording an annualized growth rate of just 1.6 percent in the first quarter, according to the preliminary release two weeks ago. Policy makers could hardly have done more to stimulate growth and yet strong growth has not yet emerged.
Will the end of the Iraq war change that? That is Greenspan's hope. Our own view, familiar to regular readers, is that it will not do. The problem for the United States is the over-capacity and excess spending built up in the late 1990s boom. After that bubble, deflation is a real possibility.
What should be the policy response? Many economists would argue that the Fed should cut rates still further. Milton Friedman, the Nobel prize-winning economist, said in an interview with United Press International two years ago in which this topic was discussed that monetary policy went wrong in the United States after the great crash of 1929 and that a looser policy after the crash might have averted the Great Depression.
Our own view would differ. We see the policy response as already having been excessive. By slashing rates so abruptly and cutting taxes so vigorously Greenspan and U.S. President George W. Bush brought the economy out of its brief 2001 recession swiftly without there being any correction in the U.S. trade deficit or in excess consumption in the United States. Now the U.S. economy's need for very high capital inflows from overseas is one of its prime weaknesses.
In addition, by cutting rates so fast Greenspan has spurred a lending binge and house price boom that has created a second asset price bubble, in housing—after the stock price one of the late 1990s. When the housing bubble bursts the debt it has created will dog U.S. households for years to come.
The roots of the United States's current weakness go back to the stock price bubble of the late 1990s. Greenspan, we feel, has been aware of the dangers ever since 2000. That is why his policy-making has been so pro-active. But still more loose money may not be solution to the disease loose money first created. Monetary policy can create problems for which it does not have an easy cure.
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