- The Washington Times - Saturday, May 24, 2003

After unleashing much speculation earlier this month in the financial markets and the media over the Federal Reserve’s concerns about the dangers of deflation, Fed Chairman Alan Greenspan went to Capitol Hill on Wednesday and delivered his take on the current status of the U.S. economy. Noting “substantial consumer and [producer] price declines in April,” Joint Economic Committee Chairman Robert Bennett, Utah Republican, opened the hearing by saying he hoped it would “serve as a fair and open forum for exploring some of the potential answers” to the “many questions about deflation.”

Interestingly, having effectively precipitated the national discussion about deflation by releasing an extraordinary statement following the Fed’s monetary-policy committee meeting May 6, Mr. Greenspan managed to deliver his prepared testimony before the JEC without once mentioning the dreaded “d-word.” No doubt that was intentional, given the fact that the Fed has no reason to fan the flames of concern because it will have the biggest responsibility for dousing any deflationary fires. This strategy seemed especially appropriate in an economic environment where price expectations can easily evolve into reality, as they have in the past.

Nevertheless, no sooner had Mr. Greenspan completed his prepared remarks than Rep. Jim Saxton, New Jersey Republican, asked Mr. Greenspan a policy question relating to deflation. What monetary-policy options were available to the Fed, Mr. Saxton inquired, in the event that its target interest rate — the overnight rate that banks charge each other for borrowed reserves — fell to zero?

Not too long ago both the question and its response would have constituted an academic exercise in hypothetical speculation. Today, however, the federal funds rate, which the Fed has reduced 12 times since January 2001, stands at 1.25 percent, its lowest level in more than four decades. Despite the Fed’s aggressive monetary expansion, which has reduced the federal funds rate from its cyclical peak of 6.5 percent, the U.S. economy remains quite weak. And further monetary stimulus, which, by definition, will push the overnight rate lower and thus closer to zero, seems all the more necessary when the next Fed meeting takes place June 24-25.

While deflation, which represents a sustained decline in the general price level, has not yet surfaced in the United States, a sustained process of disinflation, in which the rate of price increases becomes smaller and smaller as it approaches zero, has become somewhat entrenched in the U.S. economy. Meanwhile, Japan has been fighting, and losing, its nearly four-year battle with deflation. Now, with deflation accelerating, Japan’s economy seems poised to fall into yet another post-bubble recession. At the same time, European economies are facing intensifying deflationary pressures, particularly Germany, which suffered its second consecutive quarter of economic contraction in the January-March period.

With such unwelcome deflationary pressures multiplying across the world, Mr. Saxton’s timely question provided Mr. Greenspan with the opportunity in a more public forum to reiterate the Fed’s strategy, which the chairman and other Fed officials have mapped out in less public speeches over the past seven months. “[W]e have chosen to act solely in overnight funds, essentially addressing the reserve balances of the banks,” Mr. Greenspan replied, adding, “but the point at issue is that there is no legal requirement that we do so, nor indeed an economic one. And should it turn out that, for reasons which we don’t expect but we certainly are concerned may happen, the pressures on the short-term markets drive the federal funds rate close to zero, that does not mean that the Federal Reserve is out of business on the issue of further easing and expand[ing] the monetary base,” which comprises cash and the reserves banks use in the money-creation process. Because longer-term interest rates are significantly above the overnight rate, the Fed “can merely move out on the yield curve” by “essentially moving longer-term rates down and in the process expanding the monetary base and the degree of monetary stimulus.”

To drive his point home, Mr. Greenspan forcefully observed, “[W]e see no credible possibility that we will at any point, irrespective [of] what is required of us, run out of monetary ammunition to address problems of deflation or anything similar to that which disrupts our economy.”

Responding later to a specific question about deflation from Mr. Bennett, Mr. Greenspan acknowledged that, “even though we perceive the risks [of deflation occurring] as minor, the potential consequences are very substantial and could be quite negative.” Mr. Greenspan then returned to a metaphor he has used before. “We believe that, because in the current environment the cost of taking out insurance against deflation is so low, we can aggressively attack some of the underlying forces, which are essentially weak demand.”

We believe that statement describes the rationale for the Fed to increase its insurance policy against deflation by further reducing its target rate at its next meeting. To refrain from doing so would be to misjudge the favorable cost-benefit tradeoffs.

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