- The Washington Times - Monday, June 23, 2003

Today, the Federal Reserve begins its semiannual two-day meeting, during which the U.S. central bank will update its economic forecast. It will also decide how much “insurance” will be needed to counter the prospect of debilitating deflation taking hold. In congressional testimony last month, Fed Chairman Alan Greenspan rightly noted that the insurance of lower interest rates would “aggressively attack some of the underlying forces [of deflation], which are essentially weak demand.” In this context, the appropriate insurance policy is an aggressive short-term interest rate reduction of one-half percentage point.

After twelve rate cuts since January 2001, the Fed’s target short-term interest rate — the federal funds rate — has fallen from 6.5 percent to 1.25 percent, a 42-year low. Over the same period, fiscal policy also has become quite expansionary. Nevertheless, after contracting during the first three quarters of 2001, the economy has failed to achieve a growth rate high enough to prevent unemployment from rising to a nine-year high of 6.1 percent last month. Indeed, despite economic growth of 2.9 percent during 2002 (measured on a fourth-quarter-over-fourth-quarter basis), the unemployment rate increased from 5.6 percent in the fourth quarter of 2001 to 5.9 percent one year later.

Deflation has not yet arrived in the United States, although it has ravaged the Japanese economy and now seriously threatens the German economy as well. In the United States, the annual rate of inflation measured by two important core consumer price indexes, which excludes volatile food and energy prices, has ratcheted downward toward 1 percent in recent months.

Since Mr. Greenspan testified, moreover, important developments have occurred in the global economy. The Bank of Japan last week downgraded its assessment of Japan’s economy, which remains “virtually flat as a whole.” And the European Central Bank once again cut its estimate of 2003 growth in the eurozone, lowering its forecast to as low as 0.4 percent.

There have been several recent economic reports, including last week’s welcome jump in the index of leading economic indicators, suggesting that U.S. economic growth may soon begin to accelerate. However, the economies of Japan and the eurozone remain dead in the water. Meanwhile, Germany, the world’s third-largest economy, seems likely to join Japan, the world’s second-largest, in a debilitating bout with deflation. The worst possible outcome would be for the United States to join them. If “the cost of taking out insurance against deflation is so low,” as Mr. Greenspan rightly believes, then the Fed’s ideal policy action is to aggressively lower short-term rates by half a point now.

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