- The Washington Times - Thursday, May 15, 2003

Because expectations play such a pivotal role in the economy, central banks, in general, and America’s Federal Reserve System, in particular, are big into expectations. Very big. Anyone who has had the pleasure of hearing Federal Reserve Chairman Alan Greenspan’s tutorial discourse on the hugely important role inflationary expectations play in determining long-term interest rates or in shifting the so-called short-run Phillips Curve (which measures the short-run tradeoff between inflation and unemployment) can appreciate how obsessive the Fed can be in managing expectations.

To understand the intensity of the Fed’s current efforts to manage expectations as the specter of deflation haunts the American and world economies, consider this fact: Not since then-Fed Chairman Paul Volcker went into overdrive immediately following Ronald Reagan’s 1980 election has the Fed engaged in such a major battle to control expectations. Back then, at the beginning stages of its anti-inflation battle that ultimately lasted several years, the Fed required the use of a battering ram to beat down deeply ingrained inflationary expectations. Between the Nov. 4, 1980, election and Christmas Day, for example, the Chase Manhattan Bank raised its prime rate from 14.5 percent to 21.5 percent. History records that Mr. Volcker and his colleagues at the central bank eventually succeeded, but not before the economy went through its most wrenching recession since the Great Depression, as unemployment approached 11 percent.

Today, the Fed is walking a tightrope in its increasingly intense efforts to prevent the onset of a potentially dangerous bout with deflation. On the one hand, the Fed has been attempting to downplay the possible imminence of deflation. On the other hand, its senior officials, including Mr. Greenspan and fellow Fed governor Ben Bernanke, have been making speeches attempting to convince the financial markets, businesses and consumers that the Fed possesses all the requisite tools to overcome deflation should it make an appearance.

However, with unused industrial capacity increasing at the same time the economy has shed more than half a million jobs over the last three months alone, the economy’s output gap is expanding. A growing output gap, which measures the difference between an economy’s actual output and its potential output when all its capital and labor resources are used, places downward pressure on the general price level, which, according to some measures, is increasing at an annual rate of less than 1 percent. Deflation occurs when the general price level declines.

Complicating the Fed’s efforts is the fact that its principal policy lever — the overnight interest rate banks charge each other for borrowed funds (the federal funds rate) — is now 1.25 percent, its lowest rate in more than 40 years. Despite lowering it 12 times for a cumulative 5.25 percentage points since January 2001, the Fed continues to encounter declining inflation and a deteriorating economy.

What the Fed wants to avoid at all costs is the onset of deflationary expectations, which would encourage businesses and consumers to reduce spending, thus igniting a deflationary spiral that could feed upon itself in a very bad way. Beyond speeches and testimony, the Fed needs to act by further lowering its target interest rate. In the crucial expectations game, action speaks much louder than words.

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