- The Washington Times - Monday, September 23, 2002

With the Dow Jones industrial average falling below 8,000 recently and approaching the four-year low it hit in July, Federal Reserve Board Chairman Alan Greenspan and his colleagues understandably may feel reluctant tomorrow to lower short-term interest rates, fearing such action may be interpreted as an effort to prop up the stock market. Rightly so, the Fed should not be in the business of bailing out investors in the wake of the bursting of the stock-market bubble. Its primary responsibility must be the maintenance of long-term price stability. It is in the pursuit of this goal, as well as its secondary purpose of promoting economic growth, that the Fed should undertake to reduce short-term interest rates at its meeting tomorrow. In what would be its first interest-rate reduction this year, the Fed should lower its short-term target rate, the overnight federal funds rate, by one-quarter percentage point, from 1.75 percent to 1.5 percent.
While the Fed has historically pursued price stability by keeping inflationary pressures in check, today the primary challenge to price stability comes from deflation, which represents a broad-based decline in the general price level. For the first time in half-a-century, the Commerce Department has reported that the percentage change in the U.S. price deflator for non-financial business was negative for the second quarter relative to a year earlier. Producer prices for finished goods in August were 1.6 percent below their year-earlier levels. Despite a 0.3 percent increase in August, the consumer price index, which most economists believe overstates annual inflation by about 1 percentage point, was 1.8 percent above its level a year ago.
These deflationary pressures are building at a time when U.S. economic growth remains below its potential level. That means that the resulting "output gap" is growing, a fact that intensifies the underlying deflationary pressures. Indeed, as the Fed itself reported last week, industrial output fell 0.3 percent in August, its first decline since December. Meanwhile, a capacity-utilization rate of only 76 percent means that the nearly one-quarter of the economy's production capacity that remains unused will continue to exert its own deflationary pressures. Moreover, the Fed's latest "Beige Book," released September 11, reported that "economic activity has slowed in recent weeks," while there was "little or no gain in employment in July and August."
At its last monetary-policy-making meeting on Aug. 13, the Fed concluded that "the risks are weighted mainly toward conditions that may generate economic weakness" yet another factor contributing to deflationary pressures. Since then, revised figures released by the Commerce Department revealed that the Fed's crucial statistic final sales of domestic product declined during the second quarter by more than was previously reported.
As an internal study by the Fed itself concluded earlier this year, the failure of the Japanese central bank to aggressively and pre-emptively fight deflationary pressures significantly contributed to the deflationary spiral now afflicting the world's second-largest economy. Meanwhile, Germany, which confronts several of the same fiscal and structural problems as Japan, also faces mounting deflationary pressures as its economy appears to be re-entering recessionary territory. The prospect that the largest economies in Asia, Europe and the Americas could be simultaneously afflicted by the insidious, multiplying forces of deflation strongly suggests that now is the time for U.S. monetary stimulus. To prevent any misinterpretations among investors, the Fed should accompany its rate reduction with an explicitly worded statement declaring its intention to fight deflationary pressures.

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