Is the Fed Inflating the Risk of Deflation?

Second-guessing the Federal Reserve is such a common American pastime that it ought to be taxed. Imagine the revenue that could be raised even at a penny per second guess.

The money would have rolled in last week following the central bank’s surprising statement after its policy meeting on Tuesday. That was when the Fed took the extraordinary step of warning about “the probability of an unwelcome substantial fall in inflation” -- which most economists translated as a reference to deflation, or a potential broad decline in consumer prices.

That is what Japan, the home of the never-ending recession, has been dealing with for years.

Fed Chairman Alan Greenspan and peers said the chance of a U.S. deflation cycle occurring is “minor,” but they nonetheless indicated they’re ready to cut interest rates again if that’s what it takes to boost the economy and ward off deflation risks.

The stock market wasn’t sure, initially, what to think of the central bank’s warning. A strong morning rally on Tuesday faded after the Fed’s statement was issued. But the market still managed to finish the week with a net gain, as the Dow Jones industrials ended Friday at 8,604.60, up 0.3% for the week. The broader Standard & Poor’s 500 and Nasdaq composite indexes scored their fourth straight weekly advances.

The question the Fed provoked was whether the economic outlook could be much more dire than investors have been assuming. Or could Greenspan, in raising the threat of deflation, be grossly overstating that case?

The strong rally in stocks and corporate bonds since mid-March has been based in large part on the bet that the economy will pick up in the second half of the year. Why else would investors want to take the risk of buying corporate securities?

But the Fed, in its statement, said it sees as “roughly equal” the odds of faster economic growth versus a new slowdown.

The wording of the deflation warning, meanwhile, suggested that the central bank was trying to present it as an issue separate from the economic outlook. That made little sense to some.

“The Fed says deflation is a bigger concern than weaker growth. In fact, deflation would be the result of weaker growth” as businesses lose pricing power, said David Rosenberg, economist at Merrill Lynch & Co. in New York.

Whether the Fed is concerned about growth, deflation or both, its policy answer is likely to be the same, Rosenberg and other economists say: another official cut in interest rates, even though the central bank’s main short-term rate already is at a 40-year low of 1.25%.

Some investors last week saw lower rates as a foregone conclusion. Treasury bond yields fell across the board despite the government’s sale of a record $58 billion in new securities to fund the ballooning federal deficit.

The steepest move down was in longer-term Treasury yields. The 10-year T-note ended the week at 3.68% compared with 3.92% a week earlier. It wouldn’t take much more of a decline for that yield to drop below the generational low of 3.56% reached in mid-March.

That may have been exactly the reaction the Fed was hoping for. Even though many analysts believe policymakers could and probably will reduce their benchmark short-term rate in the next few months, they’re running out of bullets in that gun. Would a cut from 1.25% to 0.75% make all that much difference?

On the other hand, if the Fed can talk longer-term rates down it might be able to set off a new wave of home buying and refinancing, and also could encourage companies to refinance long-term debt to realize substantial interest savings, enhancing corporate earnings.

If deflation happens, then by definition there is no inflation. And if there’s no inflation, then bond investors might be willing to accept sharply lower yields, because inflation is what erodes the returns of fixed-income securities over time.

Fed policymakers, in comments over the last six months, also have raised the possibility that they could drive longer-term rates down by directly intervening in markets to buy long-term bonds.

Whatever level of additional stimulus the central bank might be contemplating, the question is whether the economy needs it.

It is a fact that the “core” U.S. inflation rate (consumer prices excluding those for food and energy) slumped from an annualized 2.5% in May of last year to 2.0% by December, then to a 37-year low of 1.7% in March.

That certainly smacks of a disinflation trend, and disinflation can lead to outright deflation, as Japan has demonstrated. If you figure prices are going down you may defer purchases indefinitely. That can feed on itself, causing economic activity to ebb.

But the U.S. disinflation of the last six months was powered in part by the reluctance of many consumers and businesses to spend because of the approach of the war with Iraq.

Now that the conflict is over there is good reason to expect that business spending, in particular, could begin to rise at a faster pace. And consumers certainly haven’t become shrinking violets: In April they set a record for mortgage applications to buy homes, according to the Mortgage Bankers Assn.

For the economy overall, “There is a huge amount of stimulus already out there,” said Peter Boockvar, equity strategist at investment firm Miller, Tabak & Co. in New York.

Beyond the Fed-engineered low-rate backdrop, energy prices have fallen since mid-March and the dollar has slumped to four- or five-year lows against key rivals including the euro. The weak dollar should be a boon for many U.S. exporters by giving them a price advantage over foreign competitors.

What’s more, the Bush administration is likely to get some kind of tax cut out of Congress.

All in all, “I think the economy can surprise to the upside here,” Boockvar said.

If he’s right, then any additional stimulus from the Fed could be overkill. At a minimum, the central bank could be putting the bond market at risk of a painful reversal of yields later in the year, if investors suddenly were to decide that worries about recession -- and deflation -- were severely overdone.

The Fed has some experience with overkill, its critics say. This is the same central bank that bought into the whole “new economy” theme in the late 1990s, and thereby helped to inflate the economic and market bubbles of that era.

Yet there are many who believe the only prudent path is for the Fed to risk overdoing it -- again -- with monetary policy.

“When you come out of recession you need a period of super-strong growth to heal the economy,” said Ethan Harris, economist at Lehman Bros. in New York.

The recession ended in 2001, but growth has remained subdued, and the Fed can’t just sit back and hope for better times, Harris said -- not with Europe’s economy wobbling, the SARS virus threatening Asia, and the chance that some other shock (say, a terrorist attack) could tilt the world back into recession.

The Fed may reasonably figure that Americans would forgive it for another inflation cycle, but not for being too timid if deflation is a real risk.

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Tom Petruno can be reached at tom.petruno@latimes.com.