Confusion as Fed Talks Up Deflation

What first appeared a masterstroke of Federal Reserve jawboning ended last week in a swirl of confusion.

Will Fed policymakers cut already spectacularly low short-term interest rates a quarter of a point or a half? Will they do so out of a newfound fear of deflation or just because they’re not sure the economy is recovering fast enough?

On doubt and speculation about the answers, bond prices tumbled and market interest rates jumped, and the combination put a crimp in the latest round of mortgage refinancing.

The confusion over Fed intentions was ironic, given that central bank policymakers seem increasingly convinced that clear, careful communications with the investing public is their new Big Gun in the battle to manage the American economy. And with the interest rate tool that has been their principal weapon closing in on zero, they’re desperately in need of something new.

“Talking is one of the few things they have left, and in an environment like this they need to be very clear about what they’re saying or they’re going to cause trouble,” said Tony Crescenzi, chief bond market strategist with Miller Tabak & Co. in New York.

To be fair, the Fed has been pretty clear about its aim for most of the last three years. Since deciding that the economy was faltering at the start of 2001, it has slashed its signal-sending federal funds rate faster and further than at almost any time in its history. The rate -- the interest banks charge one another for short-term loans -- is at a four-decade low of 1.25%.

To the extent that Fed policymakers are confused about what to do next, they have plenty of company. Almost no one can give a convincing explanation for why the economy has so stubbornly refused to stage a strong comeback.

This said, a growing number of economists have begun expressing doubts about the Fed’s latest moves, especially its unexpected focus on the dangers of deflation, or a general price decline.

“They’ve let themselves get swept up in the deflation delirium and it’s locked them into a rate cut that they may not want or need to make right now,” complained Chicago economist David Hale.

Tracing the recent history of the Fed’s talk of deflation shows how the subject moved from the periphery of policymakers’ attention to the center. It illustrates how useful the issue has been in justifying the central bank’s search for new policy tools to replace old, weakening ones. And it suggests the kind of trouble a continued focus on deflation could cause in coming months.

Fed Gov. Ben Bernanke gave the issue its first substantial airing in a speech last fall entitled “Making Sure ‘It’ Doesn’t Happen Here.” Although Bernanke attracted attention by suggesting the Fed might actually want to encourage a little inflation to act as a buffer against price declines, he was basically engaged in “contingency planning,” said Stephen Cecchetti, a former Fed economist now at Ohio State University in Columbus. “He was saying, ‘We’re thinking about these things and we have a plan if anything comes up,’ ” Cecchetti said.

The issue didn’t make it into a policy pronouncement until February, and then only obliquely. Alan Greenspan told a congressional committee that further rate cuts might be needed to bolster the weak economy and help keep inflation, already low, about where it was.

There matters rested until early May, when Fed officials wrapped up a routine policymaking meeting by deciding to leave the federal funds rate unchanged. But in a statement accompanying the announcement of their decision, they added this: “The probability of an unwelcome substantial fall in inflation ... exceeds that of a pickup in inflation.”

The effect on financial markets was electric. The Fed not only seemed to be declaring victory in its two-decade battle with inflation. It seemed to be saying that it faced an entirely new enemy in deflation, one that could only be defeated by driving rates as low as they could go and keeping them there.

Assured that inflation had been vanquished, investors rushed out and bought bonds, pushing their prices up and their yields, or market interest rates, down. And not just short-term but also long-term rates, the ones that determine how much it costs to get a mortgage or take out a business loan.

By mid-June, the yield on the bellwether 10-year Treasury note had fallen almost three-quarters of a point, and it had done so without the central bank reducing its already painfully low funds rate one bit.

“It was the greatest dream the Fed could ever have imagined,” said Denver economic consultant David M. Jones.

Indeed, the Fed’s recent success has seemed so great that senior Fed officials have begun to suggest that talking market interest rates down may be one of the central bank’s principal policy tools now that the fed funds rate is all but played out.

In a little-noticed speech late last month, Vincent Reinhart, the Fed’s director of monetary affairs, suggested that the central bank engage in “shaping expectations” in order to manage the economy, even without cutting rates itself.

“A central bank,” Reinhart said, “can provide impetus to the economy at an unchanged short-term interest rate by encouraging investors to expect short rates to be lower in the future than they currently anticipate.”

Which is precisely what the Fed did, according to economists, when it declared that inflation, which it had fought by raising rates, is dead and that the new enemy is deflation.

The flaw in the talk strategy is that it’s hard for the Fed -- or anybody else -- to control what people hear.

That was apparent even before last week as businesses and individuals began to worry that deflation might actually pose a substantial threat.

“Even though the Fed used terms like ‘remote possibility,’ deflation psychology got fanned,” said Sung Won Sohn, chief economist of Wells Fargo & Co. in Minneapolis.

“I think the Fed regrets using the word ‘deflation,’ ” said Diane C. Swonk, chief economist at Bank One Corp. in Chicago. “It may have added further to business hesitancy” to make new investment, a key factor holding back the economy.

The flaw in this talk strategy was even more apparent last week. New statistics suggesting a slight pickup in economic activity, and news of a modest increase in May consumer prices excluding food and energy costs, left investors wondering whether inflation is really as dead as the Fed had said and whether the promise of continued low interest rates is quite as sure a thing.

Those doubts caused bond prices to fall and market interest rates, which move in the opposite direction, to jump. They left investors and newspaper reporters scrambling to make sense of it all.

The doubts also put extraordinary new pressure on the Fed to cut the funds rate perhaps more than it thinks is needed to assure investors that it meant what it said about keeping rates low. And they made it more important than ever that the Fed explain itself.