- The Washington Times - Thursday, May 8, 2003

The Federal Reserve raised the minor but worrisome threat of an “unwelcome” drop in inflation yesterday in a move that underscores the threat of weakness in the economy.The statement, the first by the central bank, was an extraordinary concession from the nation’s chief inflation fighter. The Fed decided not to cut interest rates yesterday but said it was leaning toward doing so, partly out of concern over the possibility of a destabilizing fall in prices.The Fed said the risk is “minor,” but it was raising the possibility of a Japan-style deflationary spiral in the U.S. economy, in which falling prices force businesses to drastically cut costs and lay off workers, and cause a perpetual state of recession. The nation has not experienced such an episode since the Great Depression of the 1930s.The Fed said recent setbacks in employment and production raise questions about the economic recovery. The central bank continued to express hope that the economy will bounce back with the end of the combat phase in Iraq.Analysts said the inflation statement, which provoked a sharp fall in the dollar and in market interest rates yesterday, appears to have been prompted by a Friday report showing that businesses eliminated 525,000 jobs in the past three months, something that has never occurred here outside a recession.”Every economist appreciates the deleterious effects that slumping payrolls can have on consumer psyche, spending habits and eventually economic growth,” said Richard Yamarone of Argus Research Corp.Perhaps more disturbing, he said, is that the Fed, by choosing not to cut rates immediately, seems to be acknowledging the limits of its power to fight such a downward spiral in the economy.Having cut interest rates to 41-year lows that have inspired a refinancing wave and buying spree on new cars and homes in the past year and a half, further rate cuts are likely to provide little boost to the economy, he said.”The Fed is pushing on a string,” Mr. Yamarone said. “It’s not a very good feeling sitting on a sinking ship without any life preservers, but that’s exactly where we are.”Mark Vitner, senior economist with Wachovia Securities, was more upbeat. He said the Fed is only acknowledging that deflationary forces have taken hold in manufacturing, where job losses have totaled more than a million in the past two years and factory utilization rates are at their lowest in 25 years. The Fed is announcing its resolve to keep the forces from spreading to the rest of the economy.”The Fed has not given up on a postwar bounce,” he said, noting that the board attributed the big drops in jobs and production in the first quarter to business “decisions made before the conclusion of hostilities” in Iraq.The Fed’s statement noted that since the end of the combat, stock prices and corporate bond rates have made solid improvements, and consumer confidence has surged and oil prices have dropped to prewar levels — all developments that should support economic growth in the months ahead.”The message from the Fed seems clear: Don’t get bent out of shape over the most recent round of economic data, which were all depressed by the war. More recent data suggests the economy is already bouncing back,” Mr. Vitner said, citing an upbeat report released yesterday on chain-store sales.Richard Berner, chief U.S. economist with Morgan Stanley, said he agrees with the Fed that the shift in conditions since the war, including a decline in business uncertainty, should pave the way for better growth. But so far it has produced only glimmers of a recovery, he said.Employers have been unwilling to commit to new hires because of rising costs for health care and pension benefits, and the stop-start nature of the recovery in the past year, Mr. Berner said.But the Fed’s fight against deflation is getting help from the falling dollar, which has the effect of raising prices for such imported products as cars and electronics and enabling U.S. producers to raise their rates as well, he said.The dollar dropped an additional 1 percent, to $1.14, against the euro yesterday, bringing it near all-time lows. The dollar’s decline has been stoked by the extraordinarily low level of interest rates here compared with Europe, which is prompting investors there to keep their money at home.International corporations are reporting increased profitability owing to the fall in the dollar, which boosts their sales and earnings overseas. Eventually, it will help boost U.S. exports and economic growth as well, Mr. Berner said.Perhaps equally important to the Fed, the falling dollar, which makes exports from Europe and Japan more expensive, may be the only lever that will force officials in those places to stop relying on the United States as an engine of growth and take the steps needed to spur their economies, he said.A pickup in growth overseas would help reduce the huge U.S. trade deficit and prove to be a boon for the world as well as for the nation’s economy, Mr. Berner said.

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