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Fri, Nov 21, 2008 - Page 10 News List

Bernanke may face deflation threat

SIGNIFICANT POLICY CONCERN Prolonged declines in prices affect the economy by making debts more difficult to pay off and lenders more reluctant to extend credit

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Five years after US Federal Reserve Chairman Ben Bernanke helped stamp out the risk of deflation, the threat is returning as the financial crisis and a worsening economic slump pull inflation lower.

Fed policy makers now predict the US economy will contract until the middle of next year, according to minutes of their Oct. 28-Oct. 29 meeting released on Wednesday in Washington.

Government figures showed that consumer prices excluding food and fuel costs fell for the first time since 1982 last month.

The minutes, along with a slide in financial stocks to the lowest level in 13 years, increased the odds that the Fed will cut its benchmark interest rate next month. Bernanke may also need to revisit the unorthodox policy options, such as purchases of US government debt, that he outlined as a board member in 2003, Fed watchers said.

“The Federal Reserve put deflation back on the table as a significant policy concern,” said Vincent Reinhart, former director of the Fed’s Division of Monetary Affairs, who is now a visiting scholar at the American Enterprise Institute in Washington.

“There does not appear to be any barrier to lowering” main rate below the current 1 percent level, he said.

Deflation, or prolonged declines in prices, hurt the economy by making debts harder to pay off and lenders more reluctant to extend credit. Japan is the only major economy to have suffered the phenomenon in modern times.

“A lesson I take from the Japanese experience is not to let that get ahead of us, to be aggressive,” Bernanke’s deputy, vice chairman Donald Kohn, said in answering questions after a speech on Wednesday in Washington. “Whatever I thought that risk was four or five months ago, I think it is bigger now even if it is still small.”

Some policy makers saw a risk last month that the inflation rate will fall below their mandated goal of “price stability.”

“Aggressive easing should reduce the odds of a deflationary outcome,” they said, while noting that the low federal funds rate target “would pose important policy challenges” in that case.

The Fed’s actions so far, including unprecedented injections of liquidity, haven’t been enough to spur lending. Banks may make it even harder to get loans as their share prices plummet. Citigroup Inc closed at a level unseen since 1995. The Standard & Poor’s 500 Financials Index fell 12 percent to 139.84.

Fed officials expressed concern at last month’s meeting at the risk for “financial strains to intensify if some investors, such as hedge funds, found it necessary to sell assets and as lending institutions built reserves against losses.”

“Credit availability certainly hasn’t increased,” said Lyle Gramley, a former Fed governor.

“That has to be a major concern for the Fed because historically the way we get out of recessions is having the Fed push down hard on the accelerator. If that is not working very well, we have to look somewhere else for salvation,” Gramley said.

Future action by the central bank might include “aggressively buying long-term Treasury issues,” Gramley, a Washington-based senior economic adviser for Stanford Group Co, said in an interview.

Michael Feroli, a JPMorgan Chase & Co economist who used to work at the Fed, said the central bank could also purchase the debt of Fannie Mae and Freddie Mac, the mortgage-finance companies seized by the government in September.

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