Fed has tools to fight deflation
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May 20, 2003
(Reuters) — Financial markets are giving a lot of thought to the Federal Reserve's discussion of radical policy options after April inflation figures made the Fed's recent deflation warning seem prescient.
Two reports — on producer and consumer prices — released last week showed a sharp slowdown in the rate of inflation.
By increasing the chances of an eventual slide into deflation, those reports brought a little closer the day when the Fed might have to dig deeper into its policy toolbox.
In normal times, central banks try to stimulate growth by slashing interest rates. Stronger economic growth would help ward off deflation, or broadly falling prices, because stronger demand for goods tends to push up prices.
But with the Federal Reserve's benchmark interest rate at a four-decade low of 1.25 percent and market expectations of another rate cut this summer running high, the Fed is nearing the zone where it may have to try something other than rate cuts to fight deflation and bolster growth.
``The odds of them using unconventional policy have risen a lot,'' said Lehman Brothers chief economist Ethan Harris, who puts the chances at one in three.
Senior Fed policy-makers occasionally discuss what they call ``unconventional measures'' such as buying Treasuries to reduce long-term interest rates in the event the federal funds rate gets close to zero. A zero fed funds rate would leave the Fed without its traditional policy lever.
On Monday, St. Louis Fed chief William Poole said those special options would be effective in combating deflation. ``I'm confident that we have the tools to prevent us from sinking into a deflationary morass,'' he said.
BREAKING NEW GROUND
Many people in financial markets believe the Fed would consider such steps before the funds rate hits zero because a zero rate would roil money market funds, which rely on a positive interest rate to cover their own operating costs.
``We have so little experience with these environments that everything takes the form of new ground, where you are trying to work through what the mechanics are and the ultimate effects are,'' David Altig, the Cleveland Fed's associate director of research, told Reuters.
Less than two weeks after the Federal Reserve, in a historic shift from fighting inflation, warned about the risks of deflation, a key U.S. inflation rate dropped to a 37-year low.
Core consumer prices rose by just 1.5 percent over the year to April and prices were flat for the second straight month, figures showed on Friday. Core producer prices, which exclude volatile food and energy costs, plunged 0.9 percent in April, the steepest fall in a decade.
The Fed's worry is that if modest price increases turn into outright declines, the entire economy will be hobbled as profits and wages decline, debt burdens rise and spending is postponed as consumers and companies wait for lower prices.
``The Fed is clearly taking a hard look at their policy options,'' said Deutsche Bank Chief Economist Peter Hooper.
A congressional study on Monday said the Fed could switch its focus to longer-term interest rates with little disruption. The question of alternative tools is likely to come up when Fed Chairman Alan Greenspan testifies on Wednesday before the panel that wrote the study, the Joint Economic Committee.
Among the weapons the Fed could use — and has tried only rarely, as it did during World War Two — would be to buy two-year Treasury notes. That would put a ceiling on those interest rates, helping to bring down longer-dated bonds, which are linked to shorter-term Treasuries.
Because a wide range of consumer and business loans are tied to market rates, that would theoretically lower borrowing costs across the economy and help spur growth.
The congressional study said other forms of stimulus, such as buying foreign exchange or direct Fed lending, could be more troublesome since they would be a move into uncharted waters.
But there is likely to be a long period of public discussion before the Fed goes down the road of unconventional policy, partly to educate markets and consumers.
Trying anything radical could have an unpredictable impact on confidence and would raise questions about direct intervention in financial markets.
``They are a little worried it will create more nervousness,'' said Lehman's Harris. ``And once you start down the path of managing interest rates directly, it's hard to get out of it.'' |
