Deflation is Not the Problem

This article was published in the Australian Financial Review, June 27, 2003.

A funny thing happened on the way to deflation. For weeks, financial markets have anticipated a cut of 50 basis points in interest rates. Shortly after the last Fed policy meeting, Robert Parry, president of the San Francisco Federal Reserve Bank, strongly hinted at a future cut.

Significantly, Parry was the lone dissenter at the recent meeting, indicating a preference for a cut of 50 basis points. The actual outcome, a 25 basis point cut must signal some doubts about the deflation scenario.

The deflation story never made much sense. The US economy has not experienced zero inflation, much less true price deflation. A price index for personal consumption expenditures shows an inflation rate of 2.4 per cent for the last 12 months. A different inflation gauge, the consumer price index, was flat in May, but due only to large drop in energy prices in that month. Crude oil prices have since leapt and the price of petrol at the US pump is rising again. In short, the price trend is not deflationary.

Moreover, until the mild sell-off in equities in the last two days, the US stockmarket had been soaring to levels not seen for some time.

Since March, US financial markets have been expecting economic recovery, not deflation.

Why then do Alan Greenspan and his colleagues continue to raise the spectre of deflation? There is no question that the Japanese experience has weighed on the minds of US policymakers for some time.

Last year, an economic adviser to George Bush told me he feared a Japan-style problem in the US. The prices of financial assets were falling, the economy was weak, and monetary stimulus was not proving effective. The tax cut that the Bush administration had secured was too little and spread over 10 years.

Both Greenspan and the Bush administration fear a repetition of a 1929 crash, in which falling asset prices drive up debt burdens and shut down economic activity. Recent trade disputes remind policymakers of the breakdown in the global trading system in the 1930s, which made the global depression deeper. The risk may be small but is now viewed as palpable.

True, there are great differences between the US and Japanese economies. Japan not only had a fragile banking system but its entire financial system, including the important insurance sector, showed systemic weakness. The weakness in Japan's financial sector exacerbated the downturn. By contrast, the US banking and financial system has never been stronger.

But the parallels are there. Long before there were falling prices for goods and services in Japan price deflation the prices of financial assets in Japan were declining. As the value of assets falls, the burden of debt increases. Debt is fixed in nominal terms. When the prices of assets securing or under-girding the debt decline, the debtor must scramble to pay off his obligations.

If he sells assets to meet creditor demands, he contributes to the further decline in the prices of these very assets. And that makes the problem worse.

The Japanese financial system addressed the problem by rolling over obligations. That created the huge overhang of bad debt in the system. And it only postponed the day of reckoning. In any case, it is not a strategy available to US financial institutions. Since the savings and loan crisis of the 1980s and the banking difficulties of the 1990s, US regulators have taken a dim view of Japanese-style financial shenanigans.

In its policy statement last week, the Fed repeated its concern that deflation risk was "likely to predominate for the foreseeable future". Yet, by cutting its target rate by only one-quarter point, the Fed indicated some uncertainty about its own forecast.

To ward off even the possibility of deflation, however, the central bank wants to reflate the economy, much as it did the in the aftermath of the recession in the early 1990s. Then, the problem was a weak US banking system. Today, it is a weak US economy that continues to suffer from the excesses of the late 1990s the "bubble economy".

Low interest rates and monetary stimulus are the order of the day. Heads of central banks do not want to be on record favouring higher inflation. But higher inflation is what the Fed is proposing.

Another factor is at work: Greenspan's Fed cannot wait-and-see much longer. If it were to put off the decision until next year, it would be accused of weighing in to tilt the election to President Bush. The Fed cannot appear to have politicised monetary policy.

In the end, financial markets may negate the beneficial effects for economic activity of the Fed's expansionary monetary policy. If markets are in fact turning their attention to the possibility of inflation, long-term interest rates will rise. Higher interest rates offset the effects of monetary stimulus. Perhaps that will yet give Fed policy makers pause. For now, however, higher inflation is in store for the US economy. Global investors take note.