Federal Reserve Chairman Alan Greenspan and his central bank colleagues continue to publicly downplay the prospect of a sustained period of price deflation. But the recently released minutes of the Fed’s Nov. 6 monetary-policy committee meeting indicate that Mr. Greenspan and other Fed policymakers are focusing more intently on deflation than their public comments suggest. Given the potentially calamitous consequences of persistent deflation, which represents a state in which the average price level is falling, that is good news. What is even more important is for the Fed to take strong action against incipient deflation. This the Fed has also done; and that, too, is good news.
If it is the result of a shortfall in demand and excess capacity (two conditions that exist today), persistent deflation could be catastrophic for the U.S. economy, whose private-sector debt level has increased from 120 percent of disposable income in the early 1980s to nearly 180 percent today. Deflation causes real debts to soar, while encouraging debtors to retrench by consuming less and selling assets. Faced with falling prices, businesses would reduce employment or cut costs elsewhere, both of which compounds the economic weakness.
“Our view is that we are quite a far distance from deflationary forces taking hold,” Mr. Greenspan told Congress’s Joint Economic Committee on Nov. 13. Yet, at the Fed’s Nov. 6 meeting, when the central bank aggressively reduced its targeted short-term interest rate by one-half percentage point to 1.25 percent, its lowest level in more than 40 years, it was evident that committee members expressed a growing concern over deflation.
According to the recently released minutes of that meeting, participants acknowledged that “failure to take action that was needed because of a faltering economic performance would increase the odds of a cumulatively weakening economy and possibly even attendant deflation.” Hence, the aggressive interest rate cut, a pre-emptive step that the Fed has previously noted would be the appropriate action to thwart the onset of deflation. Noting that “the prospect of some persisting slack in resource use over coming quarters pointed to further disinflation,” which represents a reduction in the rate of increase in the price level, the minutes revealed that “some members” referred to the possibility of “a period of deflation in the event of a strongly negative demand shock.”
In fact, the process of disinflation already seems to be well-advanced. Producer prices for finished goods (essentially wholesale prices) fell by 1.6 percent last year and were nearly 2 percentage points lower in September than they were a year earlier before increasing in October. They resumed falling in November. The gross domestic product (GDP) implicit price deflator, an economy-wide measure of inflation, has decelerated to 0.8 percent over the past four quarters, a rate one-third the level for 2001 and the lowest in 50 years. Probably the most disturbing evidence of incipient deflation is provided by the Commerce Department’s price deflator for the GDP of nonfinancial corporations. In an unprecedented development over the past 50 years, it has fallen during each of the last four quarters, reflecting a decline of 1.4 percent for this period.
Japan, where consumer prices have fallen for more than 36 months in a row, has been mired in economic stagnation since the early 1990s as deflation has worsened the impact of the bursting of its stock market and property bubbles more than a decade ago. China, too, is experiencing deflation. As its economy further weakens, Germany, where consumer price inflation is 1 percent, also faces the threat of deflation.
Sometime next year, the world’s four largest economies may be simultaneously suffering from entrenched deflationary pressures. That prospect alone should keep the Fed and the rather somnolent European Central Bank (ECB) alert and poised to repeat the pre-emptive action that the Fed took early last month and the ECB belatedly pursued this month.