Fed eyes moves against deflation

With consumer prices expected to fall further, economic recovery might be tougher to achieve.

Despite the Federal Reserve's historic moves to ease monetary policy, forecasters expect consumer prices to post a rare decline this year – a potential threat to economic recovery.

The challenge: Reviving the confidence of businesses and consumers tends to be much harder when prices are falling.

In a deflationary climate, the predisposition is to postpone economic activity, because things are expected to become even cheaper.

That basic psychology, as well as the obvious distress in America's banking system, is something Fed policymakers have been weighing in recent meetings.

"[Fed chairman] Ben Bernanke is rightly concerned about deflation right now," says Desmond Lachman, a financial expert at the American Enterprise Institute in Washington. "Getting inflation back into the system … is not going to be sufficient," but it would help to resolve the financial crisis.

This idea can seem counterintuitive. The Fed's typical worry is about keeping inflation from running out of control. And it was the runaway rise in US home prices that helped set the stage for the current crisis.

Economists aren't of one mind on the right course for central bankers now. Some are concerned that efforts to revive growth could sow the seeds of an inflation problem down the road.

Yet in rare times, deflation can become a much bigger problem than inflation.

Recent indicators suggest at least a risk that this may be one of those times:

•On Tuesday, consumer confidence fell to a historic low, as measured by the Conference Board in a survey going back to 1967. The confidence of chief executives to make new business investments has also plunged in recent months.

•Standard & Poor's reported another monthly decline in its Case-Shiller home price index. A 20-city national average is down 25 percent from the home price peak reached in 2006.

•The consumer price index shifted down sharply as the recession deepened last fall. The bulk of this relates to a reversal in oil prices, but markdowns by holiday retailers were a sign of the new times.

A tally of about 50 forecasters by Blue Chip Economic Indicators finds the consensus expectation for consumer prices this year is deflation of 0.4 percent.

Declining energy prices help the economy by easing what had been a rising burden on consumers. In that sense, the recent price drop is not a bad thing.

The risk is if a deflationary psychology takes root. Consumers and business would defer decisions, which could deepen the recession and push prices down further. How does a distressed homeowner sell, when buyers are waiting for prices to fall further? Why would a "vulture" investor offer to buy a distressed bank's high-risk mortgages, if they're expecting still lower prices in the future?

In a financial crisis, deflation hits debtors especially hard. The burden of their debts is rising relative to a decline in the overall consumer price level.

Some economists say a little inflation would help turn the psychology that's part of the current crisis. "If inflation rises, nominal house prices don't need to fall as much [for the market to stabilize]," Harvard University economist Kenneth Rogoff wrote recently in Toronto's Globe and Mail newspaper.

So, what can the Fed do?

It has already cut its short-term interest rate effectively to zero. It has also moved to supply liquidity to financial markets – buying everything from mortgage-related securities to short-term debt issued by industrial firms.

The result is to help stabilize the financial system, but buying assets has also had the effect of adding to the money supply.

While the Fed hasn't emphasized this point, these policies amount to what economists call "quantitative easing" of monetary policy. By boosting the quantity of money, it fuels potential future inflation.

One idea, some economists say, is to keep expanding the money supply. Another might be for the Fed and Treasury to signal that they expect inflation to pick up once again, such as by investing in the Treasury's inflation-protected bonds.

In its meeting this Tuesday and Wednesday, Fed-watchers generally expect little new action, as the Fed waits for President Obama's economic team to define its approach the banking crisis.

"If you start to break the deflationary cycle, then people will shift out of cash," says Brian Bethune, an economist at IHS Global Insight in Lexington, Mass. "Then people will start to think about buying stocks and buying houses."