Tuesday’s dramatic cut in a key interest rate by the Federal Reserve reflects the chairman’s fear of a 1930s‐style Great Depression. The Fed cut the federal‐funds rate, the rate charged by banks to lend overnight to each other, to a range of 0 to 1/4 percentage point — an historic low.
At the same time, many see the cumulative effect of this and prior Fed moves as portending inflation. They point to the buoyant price of gold as support for their inflation fears.
So are we facing another Great Depression, or runaway inflation? Neither is likely — but, for the first time in decades, neither fear can be dismissed out of hand. That is, the US economy is being buffeted by both deflationary and inflationary forces.
For the moment — with news that the Consumer Price Index fell by 1.7 percent in November — deflation appears to have the upper hand.
But an important distinction is in order. Deflation is a sustained fall in prices — and the consumer‐price declines we’ve seen thus far largely reflect the bursting of the petroleum bubble, not any longer‐term force.
From a high of nearly $150 a barrel, the price of oil has fallen to below $41. That decline is still passing through into lower prices at the pump for gasoline — and thus into the CPI numbers.
Then, too, the economy’s weakness has dampened demand for discretionary purchases — most notably, of homes and autos. And consumers find many other ways to pinch pennies, from putting off a haircut to delaying that dentist appointment. All of this (and more) makes for further weakening of the economy — and is likely to do so into next year.
But it is unlikely to produce deflation — which, again, is a sustained fall in prices across the economy. And it is unlikely to do so precisely because the Fed chairman is haunted by the deflation and depression of the 1930s.
A student of that experience, Bernanke is well aware the depression‐era Fed dithered while the economy tanked. Money and credit contracted severely in the 1930s; he vowed never to allow that to happen on his watch.
Indeed, the Bernanke Fed has taken extraordinary measures to provide liquidity to credit markets under a wide variety of lending programs. One example is the program to purchase $600 billion of housing debt issued or guaranteed by Fannie Mae and Freddie Mac. This crisis began in housing and will end only when housing stabilizes.
In its statement Tuesday, the Fed announced it “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.” In other words, it will do whatever is necessary to prevent deflation.