A DEFLATION MAELSTROM IN THE MAKING

A DEFLATION MAELSTROM IN THE MAKING

The Federal Reserve's increasingly unconventional efforts to mend the financial markets and restore economic growth are starting to take on a new urgency. Recent data indicate the economy's descent into recession is accelerating, and the risk of a debilitating bout with deflation is rising. Given severely weak demand by U.S. consumers and businesses, along with an unexpectedly large drop in October exports, many economists now believe fourth-quarter gross domestic product could fall at a 6% annual rate. Policymakers face an uncomfortable mix of slumping demand, rising unemployment, and frozen credit. That combination, as seen in the U.S. in the 1930s and in Japan in the 1990s, is fuel for deflation.

Aiming to avert such an outcome, the Fed is pulling out all the stops. In a radical move at its Dec. 15-16 meeting, policymakers cut the target rate from 1% to a range of zero to 0.25% and committed to keep it there "for some time." The action means the Fed has all but abandoned interest rate targeting. The Fed will now concentrate on pumping money directly into the economy by purchasing "large quantities" of mortgage- and other asset-backed securities and maybe even longer-term Treasuries. The efforts are meant to cut borrowing costs and kick-start demand.

Deflation is sure to be a hot topic in the coming months. The overall inflation rate, as commonly measured by the 12-month change in the consumer price index, is bound to fall to below zero by early 2009 because of the steep drop in energy prices from last spring's high levels. But that alone would not be deflation in the true sense, which is a broad decline in prices amid falling demand that feeds further price cutting. Because true deflation casts a broader net, it would have to be evident in core inflation, which excludes energy and food.

The energy-related plunge is already showing up in month-to-month changes in the CPI, which dove a record 1.7% in November from October, the fourth monthly decline in a row. Since July the 12-month rate has dropped from 5.6% to 1.1%. Core inflation slowed from 2.5% to 2% in November, but the weakening in prices since August has been unusually sharp.

Deflation is the inflation process in reverse. That is, wages and prices spiral downward in tandem, as a deflationary psychology sets in among businesses and consumers. Wage growth always slows in a recession, and the longer unemployment stays high, the greater the slowdown. Likewise, core inflation also falls in a downturn and continues to decline until stronger growth generates more pricing power by taking up the slack in the economy.

In fact, most U.S. inflation models, which are based on the degree to which the economy is utilizing its available labor and capital, would predict deflation if slack demand were to push the jobless rate to around 9%. Right now, economists believe the unemployment rate will exceed 8% in the coming year, and not-so-idle talk of 10% joblessness is starting to crop up.

Plus, core inflation in this recession will be starting its decline from a very low level compared with past slumps. After the 1990-91 downturn, core inflation fell from a peak of 5.7% to 2.6%, and after the 2001 recession, it dropped from 3.8% to 1.1%.

Compounding matters, weak labor markets and tight credit aren't the only factors depressing demand. Using a new measure of house prices, the Fed now says consumers have lost a staggering $7.1 trillion in net worth since the third quarter of 2007. That drop exceeds the $4.2 trillion decline after the 2000 stock market collapse, and more losses in the fourth quarter could lift that total to more than $10 trillion.

As falling energy prices push inflation below zero in 2009, news reports are sure to feed deflationary psychology the same way energy's influence on inflation in 2008 prompted expectations of rising prices. But back then the economy was too weak to support broadly higher inflation. Now, the Fed is trying to ensure it will be strong enough to avoid deflation.