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Mon, May 26, 2003 - Page 12 News List

Deflation can be averted

KEEP JAWBONING Senior economists think that the likelihood of the world's largest economy falling into a deflationary spiral is unlikely, as long as the Fed is talking


The US Federal Reserve is readying a battle plan to avert a bout of Japanese-style deflation in the US, although some economists say it may win without firing a single shot.

Fed chairman Alan Greenspan is taking the deflation issue seriously and told lawmakers recently the central bank is prepared to fight deflation as fiercely as it fought to squeeze out inflation over the past few decades.

"We see no credible possibility that we will at any point ... run out of monetary ammunition to address problems of deflation," Greenspan told a congressional hearing.

Lawmakers wanted to know what the Fed could do with the base federal funds rate at a four-decade low of 1.25 percent.

"We do have the capability, should that be necessary, of clearly moving out on the yield curve -- essentially moving longer-term rates down and in the process expanding the monetary base," Greenspan replied.

Economists say the Fed chief is wisely looking at a number of options to avert a crippling deflationary spiral, including aggressive purchases of long-term Treasury bonds to pump more money into the economy.

"Unlike Japan, where the central bank sat on its hands for quite some time, and was not sure what to do, the Fed said they will do whatever is necessary to reverse deflation so whatever it takes they will do it," said Mark Vitner, a senior economist at Wachovia Securities.

Some economists said the mere mention of the deflation threat -- sometimes known as "jawboning" -- by Greenspan and company is an effective tool against it.

"The `open mouth policy' of the Federal Reserve is boosting the economy without cutting the interest rate," said Sung Won Sohn, chief economist at Wells Fargo Bank.

"Since the authorities expressed concern about deflation, Treasury bond yields have nose-dived and the value of the dollar has suffered. Housing and refinancing activities have received another shot in the arm and the yawning trade gap should receive a helping hand ... Actual deflation is highly unlikely, especially because the central bank is worried about it."

Analysts say the notion of a deflationary spiral that takes down the world's largest economy is still a remote scenario, and point out that deflation has many precedents going back in history.

"If the economy continues to grow at a rate of about two percent, negative consumer price trends could be a reality within the next two years," said Merrill Lynch chief North American economist David Rosenberg.

"That wouldn't be a disaster, in our opinion. From 1800 all the way to World War II, negative [consumer price] trends were the rule practically half of the time," Rosenberg said.

"Deflation does limit the effectiveness of monetary policy, and it raises the real cost of debt and debt-servicing, but there is no evidence that periods of mild deflation led to bad economic performance in the past," he said.

But Rosenberg added, "The real concern is whether a deflationary psychology will take hold that causes expectations of lower prices to lead to price weakness down the road, triggering a `deflationary spiral.' In our view, putting off what you can buy today simply isn't the American consumers' style."

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