Greenspan Paints Deflation Scenario

Federal Reserve Chairman Alan Greenspan said Wednesday that the nation’s central bank is capable of fighting deflation, but he acknowledged that Fed policymakers have only scant knowledge of how a broad price decline would affect the U.S. economy.

Greenspan made his comments in congressional testimony that appeared designed to provide a slightly more upbeat economic assessment than the Fed has offered in recent weeks.

At one point, Greenspan told lawmakers that forecasts of a pickup in growth this year were “not unreasonable.” At another, he said, “Readings on production and employment have been on the weak side, but the economic fundamentals ... augur well for the future.”

Greenspan went out of his way in testimony before Congress’ Joint Economic Committee to assert that the Fed had lost none of its power to manage the economy even with its signal-sending federal funds rate at a four-decade low 1.25%.

Even if it is forced to jam the federal funds rate to near zero to spur growth, “that does not mean the Federal Reserve is out of business,” he declared.

Fear that the Fed may be running out of policy options with the economy still weak is part of what’s behind the seemingly inexorable drive for another, deficit-boosting tax cut, the third in three years. House and Senate negotiators reached a tentative agreement Wednesday on a 10-year, $350-billion package of cuts.

The Fed alarmed observers this month when it suggested that deflation may be a greater threat to the economy than is generally recognized. Many took the announcement as signaling the end of the central bank’s half-century-long battle to control inflation and the start of a new and uncertain period.

In fact, in testimony Wednesday, Greenspan essentially declared victory over inflation.

“Inflation is now sufficiently low that it no longer appears to be much of a factor in economic calculations of householders and businesses,” he told lawmakers.

He has previously said that eliminating inflation from decision making was the Fed’s goal in the inflation fight.

With prices now rising at only about a 1% annual rate, Fed officials have begun saying that inflation has slowed as much as they want to see it slow, and they have stepped up talk about its opposite -- deflation.

Although Greenspan cautioned Wednesday that deflation was not “an imminent danger,” he portrayed the damage it could do to the economy as so great that the central bank must begin planning how to counter it.

“The threat, though minor, is sufficiently large that it does require very close scrutiny and maybe -- maybe -- action on the part of the central bank,” he said.

In his testimony, Greenspan offered a candid assessment of the limits of the central bank’s knowledge about deflation.

“We ... recognize that deflation is a possibility,” he said at one point, later adding: “We do ... have a problem [in] that we have not dealt with this before.”

Indeed, at times he sounded almost nostalgic for his old nemesis, inflation.

“We know how to deal with inflation.... We know how to suppress it. We know the consequences of suppressing it.... We are familiar with the mechanism,” he said.

Economists have been divided about how real the danger of deflation is. Many have noted that although the prices of such things as cars and computers have been plummeting, those for everything from houses to haircuts are still on the rise.

But almost everybody was brought up short when the Fed’s deflation warning was followed by news that the consumer price index, the nation’s chief inflation gauge, fell last month. Even when sharply declining food and energy prices were removed, the index remained stuck at zero for a second straight month, its lowest level since the mid-1960s.

Analysts have warned that unless the economy begins growing faster than the 1.6% pace it posted in the first three months of the year, prices will be tugged downward by unemployment and the huge unused capacity of business. They say the result could be a slow, downward spiral of prices that eventually would become self-reinforcing.

Greenspan told lawmakers that despite recent mixed signals, it remained too early to tell whether the economy was emerging from the funk it slipped into before the Iraq war.

He said that such discouraging signs as the unexpected loss of more than half a million jobs in the last three months reflected decisions made before the war, and so were not influenced by the pickup in consumer confidence and stock prices in the aftermath of the fighting.