Falling prices raise worries about deflation

Several forces are combining to create downward price pressure. The sharp slowdown in global growth has cut demand and created an oversupply of commodities — from oil to scrap paper — sending prices of those commodities crashing. That can translate into falling prices of finished goods.

The recent sharp pullback in consumer spending puts added pressure on producers to cut prices as they try to spur sales. Consumers will likely continue to hold back on spending as long as unemployment rises and household wealth shrinks due to dropping asset values.

If deflation were to take hold, the impact could be even worse than the 1970s inflation outbreak that devastated the economy and destroyed wealth for nearly a decade. Federal Reserve policymakers could find themselves in a tight spot. Just as higher interest rates are the antidote for inflation, lower rates are the government’s main weapon against deflation.

But having already slashed the benchmark overnight lending rate to just 1 percent from 4.25 at the beginning of 2008, the Fed is running out of room to cut rates further. In fact, as worried investors have moved piles of cash into short-term Treasuries in the past few weeks, the Fed has missed its target, and the market has pushed short-term rates to just 0.25 percent.

Fed officials are keenly aware of the deflation risk. On Wednesday, Fed Vice Chairman Donald Kohn said the “most likely outcome” was that the economy will not see an outbreak of deflation. But he said Fed policy should be focused on making sure that doesn’t happen.

"Some people have argued that we should save our ammunition, that interest rate cuts aren't effective," he said. "I think that were we to see this possibility, that we should be very aggressive with our monetary policy, as aggressive as we can be."

If deflation were to take hold, the Fed wouldn’t have to do all the heavy lifting; government policies on taxing and spending could also provide a major deterrent.

The recent, huge injection of hundreds of billions of dollars into the banking system should help offset deflationary pressures. Tax cuts could help, along with further increases in government spending on rebuilding roads and bridges. As the government pumps money into the economy and financial system that generally boosts inflation and should limit the odds that deflation could take hold.

Deflation worries surfaced earlier this decade as the economy was emerging from recession after the bursting of the Internet bubble and 9/11 terrorist attacks. Deflation concerns played a role in the Fed’s decision to keep interest rates low after the economy began recovering. Though the recession officially ended in November 2001, the Fed kept cutting rates and did not begin raising them again until June 2003.

The following month, current Fed Chairman Ben Bernanke, then a Fed governor, told a group of economists meeting that deflation was not a serious threat because “financial conditions in the United States today are sound.”

“Deflation can be particularly harmful when the financial system is already fragile, with household and corporate balance sheets in poor condition and with banks undercapitalized and heavily burdened with nonperforming loans,” he said in that speech.

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