Deflation Rears Its Ugly Head

Our February 19, 2010 blog highlighted an article in the Wall Street Journal that discussed the possibility of a Japanese-style period of deflation in the United States. The article pointed out that although inflation was slightly positive, the core inflation rate (without volatile food and energy prices) was actually negative. The concern with a widespread decline in prices is the likelihood of declining growth, stagnating wages and rising unemployment.

Since then, the US economy has stalled and the effects of the debt crisis in Greece have added to economic uncertainty. The economy appears to be taking a breather as most estimates for growth in gross domestic product the remainder of this year and into next have been revised downward. Interest rates on benchmark governmental securities are 12-18 month lows. At this point in time, the threat of inflation appears to be less of a threat than deflation in the near term.

The question now becomes what tools do the Federal Reserve have for preventing a slide to the deflationary side. Interest rates are already low so of limited use in stimulating growth. Most of the discussion centers around reinvesting the proceeds of the Fed’s mortgage-bond portfolio proceeds into Treasuries (i.e., the Fed would buy Treasuries). That would introduce more money into the economy, perhaps keeping the faltering economy from stalling and beginning a deflationary spiral. The uncertainty about the direction of the economy will undoubtedly add volatility to the market.