Posted on: Sunday, May 11, 2003

Fed attempting to avoid 'quicksand' of deflation

By Rachel Beck
Associated Press

NEW YORK — Was that the inflation-fighting Federal Reserve cheering for higher prices?

Since World War II, the Fed largely has tried to hold prices down, but its message last week was very different: Prices could be dropping too low.

And that's raising all sorts of worries over the emergence of dreaded deflation, which could weaken the sluggish economy.

That's not to say that the Fed is pushing for prices to rocket higher for any prolonged period of time, but it suggests that a blip up might help get the economy's engines roaring again.

"Deflation is like quicksand. It is very difficult to get out of. So the Fed doesn't want that to happen," said Sung Won Sohn, chief economist at Wells Fargo.

With deflation, prices fall and consumers stop spending because they think better deals are on the way. That hurts businesses, which are forced to cut prices to woo shoppers. Earnings then tumble. A vicious cycle ensues.

The last time we saw deflation in the United States was during the Great Depression. Since then, Fed policy-makers have largely focused on fighting inflation.

In fact, Fed Chairman Alan Greenspan and his predecessor, Paul Volcker, have embraced the concept of price stability, where consumers and businesses don't consider prices in their decision-making. Economists say that happens when inflation trends at about 2 percent.

But the Fed's favored inflation gauge, the price index of personal consumption expenditures, came in at an annualized rate of 0.9 percent in the first quarter.

"The Fed thinks that the current inflation rate is as low as you can comfortably go, and it would like it higher," said Lou Crandall, chief economist of Wrightson ICAP LLC.

The Fed expressed its concerns in its statement Tuesday after the meeting of its Federal Open Market Committee, which decided to hold interest rates steady at 41-year lows but warned of the troubles with sinking inflation.

"The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level," the Fed said.

Economists were quick to point out how this signaled a change in the Fed's view on prices, from worries over inflation to deflation.

Clearly, the Fed has Japan on its mind. Japan hasn't been able to tame the deflation that has crippled its economy for more than a decade.

Part of the problem in Japan was that the symptoms of deflation weren't recognized soon enough, and the Bank of Japan didn't act fast enough by reducing interest rates.

That's why Greenspan & Co. have been working hard to avoid a similar situation in the post-bubble U.S. economy.

They've been knocking down interest rates for more than two years and keeping inflation in check.

So far, though, its efforts haven't spurred much of an economic rebound.

And attempts to hold down inflation might have worked too well in certain sectors, with signs of deflation emerging in goods like electronics and apparel.

To ward off widespread deflation, the Fed likely will have to take action to boost prices. That might mean more cuts in interest rates, as well as pumping money into the economy through means like buying up Treasury bonds.

Just the threat of higher prices could help. When businesses and consumers worry that price increases are near, they often step up their spending.

"While the Fed feels that there is only a 'minor' chance of outright deflation, they appear poised to undertake maximum precautions to prevent it from becoming entrenched," Mark Vitner, a senior economist at Wachovia Securities, said in a report.

So now the Fed is rooting for inflation. Talk about changing your tune.