With the economy heading into what looks like a double dip recession, it looks like the Federal Reserve is taking deflation more seriously. It is even a hot topic on Wall Street (http://www.nytimes.com/2010/08/06/b...tml?_r=1&scp=2&sq=Goldman Sachs Morgan&st=cse) with the pessimist kicking the optimist's ass. Anyway, what can the Fed really do here considering that it may be following Japan's lead of wasting money (we don't have) on a problem as intractable as deflation?
http://www.nytimes.com/2010/08/10/business/economy/10fed.html?hp
http://www.nytimes.com/2010/08/10/business/economy/10fed.html?hp
Fed Will Meet With Concerns on Deflation Rising
By SEWELL CHAN
WASHINGTON The Federal Reserve will meet on Tuesday faced with a pivotal decision about whether to abandon its presumption that the economy is gradually picking up steam and begin to consider new steps to keep the recovery from sputtering out.
A string of developments, including the weak jobs report last Friday, has altered the sentiment within the central bank, leading Fed policy makers to stop worrying for the moment about the increasingly remote prospect of inflation. Instead, they are increasingly focused on the potential for the economy to slip into a deflationary spiral of declining demand, prices and wages.
Economists, including former Fed officials, say the central banks interest rate policy committee is likely, at the least, to acknowledge the slowdown in the recovery, and to discuss steps like reinvesting the proceeds from its huge mortgage-bond portfolio, which could help the economy by keeping more money in circulation.
Not since 2003 has the prospect of deflation been taken so seriously at the Fed, and not since the 2008 financial crisis have the markets been looking so closely to it for guidance. With Congress unwilling to embark on substantial new stimulus spending, the Fed has the only tools likely to be employed anytime soon in response to the economic warning signs.
The Feds chairman, Ben S. Bernanke, and other officials believe that the Fed, having lowered interest rates all the way to zero in 2008, still has the ability to avoid deflation. But they are also concerned that any new dose of monetary medicine could carry unintended side effects, making it harder to normalize policy in the future.
Complicating matters, a vocal minority of Fed officials is skeptical that deflation a spiral of falling wages and prices, which Japans economy has experienced since the 1990s is even a worry.
The outcome of this meeting is more uncertain than in any in at least the last year, said Laurence H. Meyer, a former Fed governor.
At the Feds last meeting, in June, the prospect of deflation was discussed for the first time this year.
Alan Greenspan, the Fed chairman for 18 years until he retired in 2006, said Friday that the economic outlook had darkened. It strikes me as a pause in the recovery, but a pause in this type of recovery feels like a quasi-recession, he said.
He added: At this particular moment, disinflationary pressures are paramount. They will not last indefinitely.
Mr. Greenspan said there had been some evidence of a pickup in inflation until the Greek debt crisis took hold in the spring. But the resulting uncertainty drove down long-term interest rates the yield on the benchmark 10-year Treasury note fell to 2.82 percent on Friday, the lowest level since April 2009, and barely budged Monday in a reflection of what Mr. Greenspan called continuing problems in the financial markets.
Mr. Greenspan declined to make recommendations or predictions for Fed policy, but on Wall Street, there is already talk that the Fed could begin a new round of quantitative easing buying financial assets to hold down long-term interest rates and increase the supply of money.
Jan Hatzius, chief United States economist for Goldman Sachs, predicted on Friday that the Fed would begin a new round of asset purchases which could include at least $1 trillion worth of Treasury securities late this year or early next year. He revised down his forecast for the growth of gross domestic product in 2011 to 1.9 percent from 2.4 percent. He also predicted that unemployment would hit 10 percent in the second quarter of next year.
Among the voting members of the central banks policy-setting Federal Open Market Committee this year, the presidents of the Feds Boston and St. Louis district banks have warned recently about the threat of deflation, while the Kansas City bank president is known for his view that inflation, the Feds traditional enemy, remains the greatest threat. But it is Mr. Bernanke who holds the most say over the outcome.
Randall S. Kroszner, a former Fed governor, said the committee was certain to alter its outlook in its statement on Tuesday.
I think the language will broadly change to acknowledge the moderation in the pace of the recovery, he said.
Mr. Kroszner said it seemed increasingly likely that the Fed could announce that it would reinvest the cash it receives as the mortgage bonds it holds mature, rather than letting its balance sheet gradually shrink over time.
In March, the Fed completed its purchase of $1.25 trillion in mortgage-backed securities. A decision to reinvest the bond proceeds in other mortgage-related securities, or in Treasuries, would be largely symbolic but carry great weight, as it would signal concern about the economy, and also make clear that an exit strategy from easy monetary policy was not imminent.
The Fed might also be poised to discuss two other options: lowering the interest rate it pays on the roughly $1 trillion in reserves that banks are keeping at the Fed in excess of what they are required to, and altering the extended period language it has been using to describe how long short-term interest rates will remain at exceptionally low levels.
Frederic S. Mishkin, another former Fed governor, said that most recoveries hit speed bumps, and that economic indicators contained considerable statistical noise. He said the Fed would be prudent not to overreact.
Its not clear the Fed needs to ease at this point, Mr. Mishkin said. If the recovery gets back on track they are still going to have to worry about an exit strategy. Quantitative easing is not a trivial matter. The expansion of the balance sheet leads to many complications for the Federal Reserve.
But Mr. Meyer, the former Fed govenor, said the committee should take into account not just the probability of various outcomes, but the potential damage associated with each of them.
Because the cost of a slowdown in growth is so dramatic relative to that of higher inflation, they should follow the risk-management strategy that Greenspan espoused during the last deflation scare, he said.
During that period, in 2002-3, the Fed kept interest rates low, as the economy recovered from the 2001 recession, to guard against deflation. Those fears did not come to pass. But some now say the Fed kept rates too low for too long, feeding the housing bubble.
It is by no means a slam dunk, Mr. Meyer said of the Feds decision.