Posted on Fri, Aug. 27, 2010
Many economists now fear the possibility of deflation
By Chris Mondics
Financial markets are down, unemployment remains painfully high, and housing sales have hit historic lows - and threaten to go lower still.
Lurking in the background is anxiety that consumer and business confidence is so shaken that prices will collapse in a deflationary spiral, cutting even more deeply into the value of homes and other assets.
With Federal Reserve Chairman Ben S. Bernanke set to make a major policy address in Jackson Hole, Wyo., Friday, are there any tools left for senior economic policymakers that can bring relief?
The answer, according to some economists and financial advisers, is a qualified yes.
Bernanke has the option of injecting even more money into the economy by buying debt from lenders, a policy known as quantitative easing, effectively providing a shot of fresh money.
But just as important as decisive action down the road is a clear statement now about what the Fed plans to do if economic conditions worsen.
"The market has been responding to uncertainty by languishing," said David Kotok, chief investment officer of Cumberland Advisors Inc. "The real economy [in the U.S.] is responding by raising its fear quotient and the rest of the world is doing the same."
Jeremy J. Siegel, professor of finance at the Wharton School at the University of Pennsylvania, said Bernanke, as head of the Fed, had the option of injecting more money into the economy by taking even more debt off the hands of lenders. But he said he doubted there would be any major announcement along those lines because of the ongoing debate among Fed governors about the best course of action.
"I would be surprised if there is a major policy shift," Siegel said.
Since the collapse of Bear Stearns Cos. Inc. and, later, Lehman Bros. Holdings Inc. in 2008, Bernanke has been leading the Fed along the path of lower interest rates and other forms of monetary easing that generally have won support on Capitol Hill and at the White House.
Although advocates insist those policies helped avert a full-blown financial collapse, unemployment remains at 9.5 percent, not far from its recession high.
Now, instead of a banking-system collapse, the talk is fixated on the economy's suffering a period of declining prices, a phenomenon known as deflation.
Deflation over the long term can be pernicious because it forces manufacturers to accept prices that, in some instances, are lower than the cost of producing the goods. It forces down the value of assets such as real estate and puts pressure on wages, making it more difficult for homeowners to repay what they owe.
Siegel and Kotok say they doubt deflation will take hold, even though there have been worrisome signals, such as sharp price declines in gasoline and natural gas.
Whatever the policy prescription, it is important for the Fed to project confidence, said Victor Li, professor of economics at Villanova University.
"I think it is important not to panic," he said. "On the consumer side, you want to make sure that consumers are willing to spend."
Within the Fed there has been debate about the correct remedy. Kansas City Federal Reserve Bank president Thomas Hoenig contends that the economy is recovering and argues for increasing interest rates, even as his St. Louis counterpart, James Bullard, has urged further easing of monetary policy to head off the risk of deflation.
Temple University economist William C. Dunkelberg said there was little the Fed can do now because consumers were tapped out. Policies such as quantitative easing that pump billions more onto the balance sheets of banks and other financial institutions will not do much good if small businesses are not expanding in anticipation of heightened consumer demand.
On that front, he said the near-term outlook was not good. His survey of small businesses shows that capital spending is at a 35-year low and that most firms plan to cut inventories.
"I don't see how lowering interest rates will do much good," said Dunkelberg, who advocates cutting payroll taxes. "There already is so much liquidity in the system right now."
Many economists now fear the possibility of deflation
By Chris Mondics
Financial markets are down, unemployment remains painfully high, and housing sales have hit historic lows - and threaten to go lower still.
Lurking in the background is anxiety that consumer and business confidence is so shaken that prices will collapse in a deflationary spiral, cutting even more deeply into the value of homes and other assets.
With Federal Reserve Chairman Ben S. Bernanke set to make a major policy address in Jackson Hole, Wyo., Friday, are there any tools left for senior economic policymakers that can bring relief?
The answer, according to some economists and financial advisers, is a qualified yes.
Bernanke has the option of injecting even more money into the economy by buying debt from lenders, a policy known as quantitative easing, effectively providing a shot of fresh money.
But just as important as decisive action down the road is a clear statement now about what the Fed plans to do if economic conditions worsen.
"The market has been responding to uncertainty by languishing," said David Kotok, chief investment officer of Cumberland Advisors Inc. "The real economy [in the U.S.] is responding by raising its fear quotient and the rest of the world is doing the same."
Jeremy J. Siegel, professor of finance at the Wharton School at the University of Pennsylvania, said Bernanke, as head of the Fed, had the option of injecting more money into the economy by taking even more debt off the hands of lenders. But he said he doubted there would be any major announcement along those lines because of the ongoing debate among Fed governors about the best course of action.
"I would be surprised if there is a major policy shift," Siegel said.
Since the collapse of Bear Stearns Cos. Inc. and, later, Lehman Bros. Holdings Inc. in 2008, Bernanke has been leading the Fed along the path of lower interest rates and other forms of monetary easing that generally have won support on Capitol Hill and at the White House.
Although advocates insist those policies helped avert a full-blown financial collapse, unemployment remains at 9.5 percent, not far from its recession high.
Now, instead of a banking-system collapse, the talk is fixated on the economy's suffering a period of declining prices, a phenomenon known as deflation.
Deflation over the long term can be pernicious because it forces manufacturers to accept prices that, in some instances, are lower than the cost of producing the goods. It forces down the value of assets such as real estate and puts pressure on wages, making it more difficult for homeowners to repay what they owe.
Siegel and Kotok say they doubt deflation will take hold, even though there have been worrisome signals, such as sharp price declines in gasoline and natural gas.
Whatever the policy prescription, it is important for the Fed to project confidence, said Victor Li, professor of economics at Villanova University.
"I think it is important not to panic," he said. "On the consumer side, you want to make sure that consumers are willing to spend."
Within the Fed there has been debate about the correct remedy. Kansas City Federal Reserve Bank president Thomas Hoenig contends that the economy is recovering and argues for increasing interest rates, even as his St. Louis counterpart, James Bullard, has urged further easing of monetary policy to head off the risk of deflation.
Temple University economist William C. Dunkelberg said there was little the Fed can do now because consumers were tapped out. Policies such as quantitative easing that pump billions more onto the balance sheets of banks and other financial institutions will not do much good if small businesses are not expanding in anticipation of heightened consumer demand.
On that front, he said the near-term outlook was not good. His survey of small businesses shows that capital spending is at a 35-year low and that most firms plan to cut inventories.
"I don't see how lowering interest rates will do much good," said Dunkelberg, who advocates cutting payroll taxes. "There already is so much liquidity in the system right now."