WSJ -- Inside the Fed, Deflation Is Drawing a Closer Look.
November 6, 2002
Inside the Fed, Deflation Is Drawing a Closer Look
Stumped for a Cure, Officials Study How To Keep Prices From Falling in First Place
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
Alan Greenspan and his colleagues at the Federal
Reserve have spent their professional lives fighting
inflation. But in the fall of 1999, central bank officials
gathered at a country inn in Woodstock, Vt., to talk
about the opposite: What would they do if faced with
deflation, or widespread falling prices, and they already
had cut interest rates to zero?
Deflation is dangerous because it makes it hard to boost
the economy by cutting interest rates, and because it
makes debt, now at a postwar high in the U.S., harder
to repay.
At Woodstock, researchers brainstormed about possible ways the Fed could spur spending, such as adding a
magnetic strip to dollar bills that would cause their value to drop the longer they stayed in one's wallet.
At the time the chance of deflation in the U.S. seemed remote. Inflation was low, but the economy was
booming and the Fed had lifted short-term interest rates above 5%.
Today, deflation no longer seems so remote.
Prices of consumer goods, as opposed to services, are falling for the first time since 1960. By the Fed's
preferred measure, overall inflation was just 1.8% in the year through August. Fed policy makers have cut
short-term interest rates to a 41-year low of 1.75%, and investors expect them to cut rates again in coming
months to as low as 1.25% -- perhaps starting at their meeting Wednesday.
The U.S. economy is struggling with the collapse of a gigantic stock mania. Sinking prices for telecom
services, to name just one conspicuous example, are already making it harder for some businesses to support
their heavy debts.
Overseas, Japan is in its fourth year of declining prices even with interest rates near zero, a result of a decade
of economic stagnation that followed the bursting of its real-estate and stock bubble. China has experienced
intermittent deflation since 1999 and a few economists think Germany may be close. The International
Monetary Fund projects that inflation in industrialized countries this year will hit 1.4%, its lowest level in more
than 40 years.
Fed officials and most private economists still think deflation is
highly unlikely. While the Fed is expected to cut rates either
Wednesday or in December, that's more out of concern about
slow growth, not deflation. Most Fed officials feel that the 1.75
points of rate-cutting room they have left is plenty to get the
economy growing briskly again.
Still, they are all thinking more about deflation. "Whereas this possibility wasn't even on radar screens in past
recoveries, it is in the range of plausible risks now," Al Broaddus, president of the Federal Reserve Bank of
Richmond said last month. "We need to be alert to this risk."
Shouldn't consumers be happy when prices fall? That depends on what causes deflation. When technological
progress leads to rising productivity, or output per hour of work, the economy can produce more each year
with the same workers and equipment, and companies can cut prices while increasing sales. Between 1865
and 1879, manufacturing output rose 6% a year while prices fell by 3% a year. Wages were basically
unchanged.
Deflation is more worrisome when it results from declining demand, as it did during the Great Depression
when prices tumbled 24% between 1929 and 1933, bankruptcies mounted, thousands of banks failed and the
unemployment rate hit 25%.
It is a central banker's nightmare. William McDonough, the 68-year-old president of the Federal Reserve Bank
of New York, recalls his father taking him in the late 1930s to see breadlines and "people in jail who were there
for stealing food for their families." The Depression, he said in a speech in March, "was a very real thing to the
people who created the Federal Reserve's mandate and they never wanted it to happen again."
The 1930s demonstrate that deflation is most dangerous when debt burdens are heavy, as they were in the
1920s and are today. "When a deflation occurs ... without any great volume of debt, the resulting evils are
much less," Yale University economist Irving Fisher wrote in 1933. "It is the combination of both ... which
works the greatest havoc."
A company borrows on the assumption that rising sales volumes and prices will enable it to repay the debt. As
prices fall, it becomes more difficult to make payments on debt. A company may be forced to cut wages or
jobs, or go bankrupt. The same applies to households that suffer falling income and have to cut spending to
service debts. If too many businesses and households do this, the result is depressed demand that fuels further
deflation. "The more the economic boat tips, the more it tends to tip," Mr. Fisher wrote.
Another risk from deflation is that consumers may delay spending because they expect goods and services to
get cheaper. However, there's little evidence that has ever happened -- even in Japan.
More troublesome is that deflation makes it impossible for a central bank seeking to jump-start the economy to
get inflation-adjusted interest rates -- the ones that economically matter -- below zero. (When inflation is at 3%
and the Fed cuts rates to 2%, the inflation-adjusted rate is minus 1%.) For that reason, modern central bankers
consider a low inflation rate -- typically between 1% and 3% -- ideal. The U.S. is now in the lower part of that
range.
Most economists say it would take another massive shock, such as the Sept. 11 terrorist attacks, or demand
persistently growing slower than supply to create so much excess capacity that prices fall. Macroeconomic
Advisers LLC, a St. Louis, Mo., consulting firm, estimates the economy would have to get so bad over the
next four years that it pushes unemployment up to 7.5% from the current 5.7%. "It's a pretty ugly scenario
that's required," says the firm's chairman, Joel Prakken.
The odds of deflation also are damped by the fact that inflation has been low and stable for years. As long as
businesses and consumers expect that to continue, and set prices and wages accordingly, the deflation risks
are diminished.
Tilted Toward Deflation
But a few economists think current economic circumstances are tilted toward deflation. The 43% plunge in
stock prices since early 2000 will pressure households for years to spend less and save more. Should home
values also see a major decline, families' ability to repay mortgages and spend on other items would fall further.
Deflation doubters say the U.S. won't suffer deflation again because the Fed won't let it. "There's a much
exaggerated concern about deflation. It's not a serious prospect," asserts Nobel Laureate Milton Friedman,
now at the Hoover Institution. Mr. Friedman, the best-known proponent of the view that prices rise and fall
with the quantity of money in circulation, says, "The cure for deflation is very simple. Print money." At the
moment, with the money supply growing briskly, he argues, "Inflation is still a much more serious problem
than deflation."
Scholars blame the deflation in the 1930s on the Fed's refusal to accept responsibility for maintaining stable
prices. The Fed instead was focused on keeping the dollar's value in gold fixed, says Mr. Friedman, who adds,
"Today's Federal Reserve is not going to repeat the mistakes of the Federal Reserve of the 1930s."
Since at least 1997, the Fed's professional staff has been studying deflation and the problem of how a central
bank stimulates the economy once interest rates are already at zero. Mr. Greenspan and other Fed policy
makers have been thinking more about it lately. They devoted a chunk of their January policy meeting to the
subject. New Fed governor Ben Bernanke, a Princeton University economist who has studied the 1930s, is to
give a speech on deflation later this month called "Making Sure It Doesn't Happen Here."
Deflation today would likely be more serious than when prices declined in 1949 or 1955 because Americans
are so much more in hock. Total debt, excluding the federal government, now equals 158% of gross national
product. The last time debt rose to that level was in the late 1920s. Indeed, both the 1920s and 1990s saw a
surge in new forms of debt-financed consumption -- installment plans in the 1920s, "cash out" mortgage
refinancings in the 1990s.
But the fact that consumer debt has doubled since the 1950s to 90% of personal income isn't of great concern
to Fed officials. They attribute it to a more sophisticated financial industry that has made credit easier to get,
and to the rise in home ownership which means many people have substituted mortgage payments for rent.
During the Depression, mortgage default was a cause of considerable hardship, because of the structure of the
mortgage market, says Kent Colton of Harvard University's Joint Center for Housing Studies. Homeowners
generally had to pay the entire principal back in five to 10 years. If they couldn't refinance, they defaulted. At
the depths of the Depression, some 40% of mortgages were in default. The defaults and declining home values
also contributed to the failure of thousands of banks and thrifts.
Now, thanks to mortgage insurance and the creation of mortgage agencies Fannie Mae and Freddie Mac,
homeowners can pay their mortgages down over 30 years and easily refinance to take advantage of lower
interest rates. While delinquencies on both credit-card and mortgage payments are on the rise, the problems
have been concentrated among subprime borrowers, or those with poor credit.
The corporate debt burden, which has also doubled since the 1950s to 89% of revenue, is more worrisome.
One indicator of investors' concern about companies' ability to pay back the debt is that yields on
medium-quality corporate bonds are 2.7 percentage points higher than those on safe Treasurys -- the widest
spread since 1986. "Companies simply aren't coming up with the cash flow they thought they would when
they took on the debt," says John Lonski, chief economist at Moody's Investors Service.
Automobiles illustrate the pressures. In the 1950s, car prices rose about 0.5 percentage points a year faster
than inflation, says Sean McAlinden, chief economist at the Center for Automotive Research in Ann Arbor,
Mich. Car makers' productivity was rising rapidly, and sales were advancing 3% to 4% a year. In today's
dollars, manufacturers earned about $1,500 per vehicle. Today productivity is growing more slowly, the world
is awash in idle auto factories and a strong dollar is holding down the price of imported vehicles. As a result,
Mr. McAlinden says, new car prices have fallen 0.2% a year since 1996 and profits per vehicle are down to
about $400.
That is making investors increasingly nervous about auto makers' ability to repay huge debts, which are mostly
to finance customers' car purchases. As recently as 1980, Ford Motor Co. had the highest available credit
rating; now, its bonds trade as if they were junk. In the 1930s, Mr. McAlinden says, "we had both deflation
and absolute falling demand. This time we just have falling prices." So far. A renewed recession, which would
drive down auto sales, is "the most frightening prospect this industry cares about," Mr. McAlinden says.
What would the Fed do if it confronted imminent deflation? A study by 13 Fed economists this summer
concluded that Japanese policy makers didn't see deflation coming until it was too late to prevent it. The
authors concluded that "when inflation and interest rates have fallen close to zero, and the risk of deflation is
high," policy makers should respond more aggressively than economic forecasts suggest. If the Fed lowers
interest rates too little, deflation could result, rendering the Fed less potent. If the Fed overdoes it, it can
always raise rates later to suppress the unwanted inflation, the study says.
Less Relevant?
Fed officials argue that they applied these lessons last year, cutting rates 11 times, and say the lessons are less
relevant now, with the economy growing, albeit slowly. But Martin Barnes, editor of the Bank Credit Analyst, a
Montreal-based forecasting journal, warns that prices received by most businesses are already declining. While
a near-term rate cut by the Fed might help, he says, it "is not going to prevent deflationary pressure from
intensifying over the next few months."
The federal government could also fight deflation by boosting spending or cutting taxes, though the recent
surge in the government's budget deficit could make that more difficult.
If the Fed cut its target for short-term interest rates to zero, and still feared deflation, its next steps are largely
untried. It could purchase large quantities of government bonds to lower long-term interest rates and perhaps
prompt investors to shift assets to stocks. It could purchase more government securities from banks, leaving
banks flush with newly created cash to lend. It could try to create inflation by purchasing foreign currencies to
drive down the dollar and push up the price of imports.
But Fed economists who studied these strategies in late 2000 were skeptical. If interest rates were zero, then
even if the Fed did pump banks full of cash by purchasing government securities, the banks would have little
profit incentive to risk lending out the money -- the return from leaving it in their vaults would be the same.
Indeed, the Bank of Japan has tried this "quantitative easing" for the past year, and the economy is still in a
slump. Driving down the dollar would fail if other countries tried to depreciate their currencies, too.
Other proposals, some possibly not legal, were for the Fed to lend to private companies or buy things such as
stocks, real estate or even goods and services, such as used cars. And then there are those magnetic strips.
Marvin Goodfriend, a top economist at the Richmond Fed, proposed at the Woodstock conference that a way
to stimulate the economy if interest rates are already at zero is to levy a fee on banks that keep cash on deposit
with the Fed rather than lending it out, and to find a way to make currency worth less the longer it goes
unspent -- thus the magnetic strips. When someone deposited a bank note, a "carry tax" would be deducted
according to how long it had been since it was withdrawn. These charges for holding on to cash would
effectively create negative interest rates.
"Asking people to carry around some one-dollar bills that are worth 99.4 cents and some that are worth 98.4
cents would be a terrible nuisance," Alan Blinder, a former Fed vice chairman, observed at the Woodstock
meeting. He added, "Prevention is far better than the cure."
Write to Greg Ip at greg.ip@wsj.com
Updated November 6, 2002
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