Federal Reserve Chairman Alan Greenspan recently assured Congress that "we are not close to a deflationary cliff," and that should the United States ever get near such a dangerous place, the central bank has the tools necessary to flood the country with money and get prices up and the economy moving again.
In a speech last week to the National Economists Club, Fed Governor Ben S. Bernanke, an expert on monetary policy, acknowledged that some people have expressed concern that the nation could face a deflation -- a general decline in prices -- a perilous, debilitating circumstance in which borrowers have to repay their debts in dollars worth more than those they borrowed. That added burden could force many borrowers into bankruptcy and damage the U.S. financial system, he said.
Bernanke agreed with Greenspan that, at present, the U.S. economy is too resilient and too stable for some type of shock to generate a deflation. He said the Fed would act aggressively to head off such an episode should one threaten. Even if very short-term interest rates were to fall to zero, a possibility in a deflationary situation, the Fed would still have ways to deal with the problem, he said.
One reason for the concern about deflation expressed by some analysts and a few members of Congress is that the Fed's target for overnight interest rates was lowered earlier this month to just 1.25 percent. That raised fear that the Fed could run out of "ammunition" to stimulate the economy and ward off deflation.
Not so, Bernanke said. "Under a paper-money system, a determined government can always generate higher spending and hence positive inflation," he said.
Under its current procedures, the Fed buys U.S. Treasury securities from private dealers in exchange for cash when it needs to add money to the banking system to keep overnight rates close to its chosen target. When it needs to take out money, the Fed reverses the process.
Longer-term interest rates are influenced by changes in the target but are set by market forces, not the Fed. If the target is at zero, Bernanke said, one way to add money to the economy would be for the Fed to set a target for yields on a particular set of Treasury securities below those established by trades in the market.
The Fed could "begin announcing explicit ceilings for yields on longer-maturity Treasury debt -- say, bonds maturing within the next two years. The Fed could enforce those interest rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields," Bernanke said. Because of linkages among various types of securities, the Fed action probably would reduce yields on longer-term public and private debt, such as mortgages, he said.
The Fed also could pump out money by making loans to banks backed by many types of collateral, such as promissory notes from businesses, by buying securities of foreign governments, and by using other channels, Bernanke said.
The only truly serious deflation the United States experienced in the past century was at the beginning of the Great Depression, when prices fell about 10 percent a year from 1930 through 1933. In a new book, "A History of the Federal Reserve, 1914-1951," economist Allen Meltzer of Carnegie Mellon University says the deflation and the Depression were primarily the result of a mistaken Fed policy that allowed the money supply to decline sharply. That policy was reversed when President Franklin D. Roosevelt devalued the dollar against gold and the resulting inflow of gold led to a renewed expansion of the money supply.
Last week Meltzer told an audience at the American Enterprise Institute that he was confident the Fed, using different tools, could deal with any deflationary threat.
Many financial analysts agree with that assessment, but they caution that times could still be tough despite Fed action to flood the economy with money. In a deflationary situation, however it came about, American consumers and businesses might have become so worried and uncertain about the future that they hold back on spending, even with interest rates at rock bottom and plenty of cash available.
Bernanke said in his speech that the current concern about deflation "is not purely hypothetical" because it "is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation -- a decline in consumer prices of about 1 percent a year -- has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors."
Overnight interest rates in Japan have been pegged at zero by the Bank of Japan, that nation's central bank. But with deflation, when the nominal rate is zero, the inflation-adjusted rate, which is more important in terms of influencing economic decisions, is actually about 1 percent.
But the inability of the Japanese government to deal with its deflation using monetary policy tools, Bernanke said, is not that the tools are inadequate but that the country faces several problems, including a huge overhang of bad loans on the books of its banks.
"The failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal," he said. "Rather, it is a byproduct of a long-standing political debate about how best to address Japan's overall economic problems." Actions to deal with those problems "will likely impose large costs on many, for example, in the form of unemployment or bankruptcy," he added.
In contrast, the U.S. financial system is in good shape, with financial institutions holding enough capital that they can absorb even very large losses, such as those associated with the bankruptcies of Enron, WorldCom and some other large companies, without severe damage to their balance sheets.