Deflation fear guided Fed
Consumers anxious about the worsening economy might welcome the prospect of falling prices. But fear of a general price decline that could worsen the economic downturn was one reason the Federal Reserve slashed interest rates to as low as zero last month.
According to minutes released Tuesday of the Fed’s meeting Dec. 15 and 16, in which policymakers cut the central bank’s benchmark rate to a range of zero to 0.25%, down from 1%, it was a fear of economic catastrophe that persuaded them to open the monetary spigot as wide as possible to keep the foundering economy from running aground.
“The overwhelming message gleaned from the minutes of the meeting is one of fear -- fear of a deep recession and fear of a debilitating deflationary spiral that would capsize a debt-laden economy,” said Joshua Shapiro, chief U.S. economist at forecasting firm MFR Inc.
President-elect Barack Obama met Tuesday with his economic advisors as they continued to draw up a plan to try to prod the economy out of its doldrums. Obama is scheduled to address the economy at a news conference today.
During their meeting last month, Fed officials expressed concern about a “prolonged recession,” although “that was not judged to be the most likely outcome,” the minutes say.
The consensus was that the economy would continue to contract into the middle of 2009 before beginning a slow turnaround.
Still, the specter of deflation flitted throughout the 11-page document. Notably, the Fed appeared to go out of its way to avoid using the word. Instead, it referred to inflation declining to “uncomfortably low levels.”
“I don’t know why they are so skittish when it’s very clear that that is what they are talking about,” said Gus Faucher, an economist at Moody’s Economy.com.
Although some price declines can be good news for consumers in the short run, if price drops become too deep and too widespread, they can intensify a recession.
One reason is that even consumers and businesses with cash to spend will start putting off purchases, anticipating further price drops in the future. And unemployment accelerates not only because of declining demand for goods and services but also because falling prices make the wages of people still working appear ever more costly to the employer.
Vincent Reinhart, a former director of the Fed’s board of monetary affairs, said the minutes avoided the term “deflation” because the central bank considered it highly unlikely that inflation would quickly fall below zero and trigger the worst-case scenario.
“Inflation doesn’t move fast, but it moves in unpredictable ways,” Reinhart said. “So they are drawing the lines of battle and they are showing there is a line of battle before deflation.”
In general, the Fed likes to see annual inflation of 1% to 2%. The consumer price index climbed 1.1% in the 12 months that ended in November.
“The reason is simple: If you have zero and things get slow, you go to deflation. If you have 1%, you have a little cushion,” said Joel Naroff, president of Naroff Economic Advisors in Holland, Pa. Fed officials “are basically saying that they wouldn’t be surprised to see inflation go below 1% for a while.”
Although the Fed is using monetary tools to try to stimulate the economy, the incoming president is preparing a large fiscal stimulus plan -- even though it will swell the federal budget deficit.
Obama said Tuesday that his choice for budget director, Peter Orszag, was forecasting a nearly $1-trillion budget deficit for the current fiscal year and “that potentially we’ve got trillion-dollar deficits for years to come.”
“So the reason I raise this is that we’re going to have to stop talking about budget reform,” Obama said. “We’re going to have to totally embrace it. It’s an absolute necessity.”
In September, the nonpartisan Congressional Budget Office projected the deficit for the current year, which ends Sept. 30, would be $438 billion. But that did not include the $700-billion financial rescue package. The budget office plans to update its projections today.
Obama vowed that his stimulus plan, expected to include significant spending on infrastructure projects, wouldn’t contain any congressional pet projects. He also promised to set up an “economic recovery oversight board,” made up of members of his administration and independent advisors, to monitor the stimulus plan.
“We are going to bring a long-overdue sense of responsibility and accountability to Washington,” Obama said.
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jim.puzzanghera@latimes.com
