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Fed determined to prevent deflation in US

The US seems determined to cut interest rates to a 45-year low in a preemptive anti-deflation strike, but early disquiet is emerging of the risk of a housing bubble.

US Federal Reserve chairman Alan Greenspan and his colleagues are expected to trim the key federal funds rate from 1.25 percent now to a 45-year low of 1.00 percent, possibly even 0.75 percent.

The Federal Open Market Committee meets tomorrow and Wednesday, releasing the decision with an explanatory statement.

Early signs of a tentative turnaround in the US economy led many economists to predict policymakers will opt for an interest rate cut of a quarter percentage point.

Greenspan has alerted the financial markets he wants to nip in the bud even a "remote" threat of deflation, which depresses consumer spending and raises real interest rates.

With inflation fears all but vanquished, analysts said he could squash deflation before it emerges, and at very little risk, by trimming interest rates now.

Even more important, however, the Federal Reserve wanted to convince the financial markets that it would keep interest rates low for as long as it took to reflate the economy.

"Ever since rates got where we are now, and before, people started asking: `When do they start turning this around because rates are so low?,'" said Naroff Economic Advisors president Joel Naroff.

"They are fighting that expectation now," Naroff said. "The reality is that they have got to break that expectation. That is the message they have got to send."

Citigroup economist Steven Wieting agreed.

Inevitably, as the economy built up steam, people traditionally would ask when the Federal Reserve would begin to tighten interest rates and stamp out the recovery, he said.

"That is not their job," Wieting said.

"The economy is below potential," he said. "They should ideally be able to tolerate a fairly prolonged period of above-trend growth before we are dealing with an economy bumping up against capacity constraints and threatening inflation."

Driving interest rates so low carried risks, however, beyond the already widely cited concerns about how far the Federal Reserve could cut rates before it ran out of room.

"Whether we realize it or not, the Fed is running the risk of inflating potential speculative bubbles by taking Fed funds down to 1.0 percent or lower," said Moody's Investors Service chief US economist John Lonski.

Last month, the US had experienced the biggest jump in money supply since the Sept. 11 2001 attacks, when the Federal Reserve took emergency action to pump liquidity into the markets.

This time, the money supply was being boosted by home owners flocking to re-finance their mortgages at lower interest rates, Lonski said.

Low interest rates risked feeding a treasury bond market bubble, and as a result a mortgage bubble, he said.

"That could prove quite damaging to residential real estate in the event that the Fed does find itself facing a rising inflation threat late 2004 [or] 2005 and as a result sharply higher 10-year treasury yields drive mortgage yields up to such a height that we suffer a drop in residential real estate values," Lonski said. "That is the risk right there: that you perhaps unnecessarily lower Fed funds to such a level that you are perhaps risking some future destabilization in the finanical market once the Fed has to tighten to ward off the build up of inflationary pressures."
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