- The Washington Times - Wednesday, May 14, 2003

Five months ago, in a speech before the Economic Club of New York, Federal Reserve Chairman Alan Greenspan declared that “the United States is nowhere close to sliding into a pernicious deflation.” Nevertheless, Mr. Greenspan noted at the time, the Fed was engaged in a “heightened level of scrutiny,” the objective of which was “to ensure that any latent deflationary pressures are appropriately addressed well before they become a problem.”

Five months later, those pressures now appear to be, at the very least, potentially problematic. Indeed, last week the Fed’s monetary-policy committee issued a stunning statement. Officially acknowledging for the first time since the end of the deflation during the Great Depression, when the general price level collapsed, causing bankruptcies nationwide on a massive scale, the Fed warned that “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.”

Given that Mr. Greenspan’s favorite inflation gauge — the price index for personal consumption expenditures excluding food and energy — fell below an annual rate of 1 percent during the first quarter, it’s clear why a “substantial fall in inflation” would be so “unwelcome.” As a matter of simple arithmetic, very little room now remains between disinflation (a decline in the rate of increase in inflation) and deflation (an actual decline in the general price level).

Moreover, since Mr. Greenspan’s December speech, the economy has markedly slowed down. The economy’s annual growth rate has plunged from more than 3.25 percent (October 2001 through September 2002) to less than 1.5 percent (October 2002 through March 2003). As a result, today’s domestic economic environment has been increasingly afflicted by a large and expanding output gap. Under current conditions of very low inflation, the output gap is the potentially deflation-inducing difference between an economy’s actual output and its potential output. Given these circumstances, “pernicious deflation” is much closer today than it has been in decades. Consider also the reality that Japan has been mired in deflation-induced stagnation for years and the fact that the condition of the eurozone economy deteriorates on a weekly basis.

What to do? The Fed and Congress ought to follow the advice of a June 2002 Federal Reserve research paper, “Preventing Deflation: Lessons from Japan’s Experience in the 1990s,” which Mr. Greenspan himself has widely cited. “[W]ith the benefit of hindsight, perhaps the most important concern raised by Japanese policy during this period,” the paper concluded, was that policy-makers “did not take out sufficient insurance against downside risks through a precautionary further loosening of monetary policy.” While earlier monetary loosening in Japan “seemed appropriate,” the paper concluded (perhaps in a veiled reference to the Fed’s aggressive actions in 2001) that “this loosening proved to be inadequate.” In retrospect, “compared with the costs of entering into deflation, the costs of excessive monetary loosening would have been relatively limited.”

On the fiscal-policy front, the Fed’s paper was equally emphatic. It would have been much better for Japan to err on the side of sufficiency than inadequacy. The “general lesson” drawn from an examination of the Japanese experience was this: “[W]hen inflation and interest rates have fallen close to zero” — as they clearly have in the United States today — “and the risk of deflation is high” — even the Fed officially admits the risk has grown significantly — then “stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.”


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