Based on October wholesale and consumer price reports, July 2008 marked a shift from inflation into full-blown deflation. This has much to do with the declining price of oil, which in turn is related to the collapse of speculative buying of oil while shorting the dollar; the decline in demand resulting from a global downturn; and the failure of producers to cut supply fast enough.
However, as I posted, there's a vicious cycle underway which leads to:
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Excess inventory,
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Price cuts,
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Capacity and job reductions,
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Less spending power,
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Lower demand -- followed by a return to step 1.
And with jobless claims at 542,000 and the price of oil down below $50, it's pretty clear that this cycle is well underway. What can the Federal Reserve do to turn this vicious cycle into a virtuous one? It is likely to cut the Fed Funds rate to zero or very close to it -- 0.25% -- in January. But in a 2002 speech, Bernanke said that there are other ways the Fed could try to boost overall demand, which would reverse the deflationary cycle.
The Fed could start to lower interest rates on longer-term maturity Treasury bonds -- for example those maturing in two years. Bernanke thought this could be done by announcing yield ceilings on that debt which it could enforce by making "unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields." Bernanke also alluded to fiscal policy -- outside the Fed's control -- such as tax cuts and/or government spending as other ways to boost demand.
Will any of these tactics actually work to increase demand? The efforts to lower interest rates won't, but the government spending and tax cuts might. How so? Lower interest rates will only work if banks are willing to lend to businesses and consumers. But banks are too worried about getting paid back to make the loans. And they should be because many consumers and businesses are likely to have less income to pay back those loans.
However, if the government simply gave enough money to businesses and consumers, they would probably first use it to pay off their debts then put more aside in savings for a rainy day. If the amount of government stimulus was big enough, after doing the first two things, businesses and consumers would probably decide that they should spend the money.
My hunch is that such a plan would involve stimulus spending of at least $3 trillion to $5 trillion. But if such spending yielded an increase in demand, then businesses would start to add productive capacity and hire people to operate the plants. That would boost workers' incomes, which would then cause spending to rise. This could pose a huge inflationary risk once the economy got going again. But presumably, the Fed could then start raising interest rates to rein in that inflation.
For the time being, the Fed's power to fight deflation looks deflated to me -- it's up to fiscal policy now.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.
Reader Comments (Page 1 of 1)
11-20-2008 @ 2:06PM
beachpaul said...
Bernanke talked about deflation when he was first appointed. It was dismissed as highly improbable by all the media. Tell the truth now. Japan went to zero percent. It didn't work. We allowed our real estate to inflate just as they did in the last century. We will get the same results they got. To expect different results will only perpetuate the insanity that brought us here.
11-20-2008 @ 3:24PM
Kent said...
This article is right on the mark by Peter Cohen about deflation and so was Beach Paul's. Lowering interest rates do little to spur the economy out of its deflationary stall (I call it, stagflation) if both banks and consumers aren't willing to lend and spend, respectively. I also do not think a stimulus package will cure the fundamental ills in our economy either. Japan's doldrums is a classic case of what can happen to us if our government doesn't make the right decisions. Like Japan, consumers and banks will be hoarding their cash until the economic climate improves.
11-20-2008 @ 3:58PM
RickRussellTX said...
Something tickles the economic funnybone when the cure-all for economic woes is to convince consumers to spend more. If they won't spend more, give them money to spend! Problem solved!
Spending more is what got us into this mess in the first place -- carrying the biggest mortgage you can fit into the family budget, carry the biggest credit card bill that you can, buy the most expensive car if you can handle the auto loan.
This frivolous spending is what caused housing prices to spiral out of control and has caused consumer spending to exceed consumer income for several years running.
It is laughable to think that this will lead to modest growth with low volatility. The solution is the same as its always been -- to produce durable goods that are in demand all over the world, control costs, and sell them for a competitive price. The Fed can help with this task by keeping liquidity high, but they can't solve the basic problem.
Keynes always played up the demand component of the economy, but he also realized that the only real solutions involved putting people to work and building out heavy-duty infrastructure that would serve as the foundation of the manufacturing economy for decades. We're not going to right ourselves and continue on a steady economic climb by serving ourselves double lattes or getting a good deal on a flat panel at Wal-mart.
Think of the kind of public works projects we could build with $700 billion in bailout money -- the kind of projects that would reduce the cost of business and create an innovation economy that would bring benefits for decades. Nuclear power, high efficiency electric transmission, improved roadways, support for university research and education.
I mean, just the NIH and the NSF have a combined budget of less than $35 billion per year. And we can't think of a better way to spend $700 billion?