Fed Marks End of Deflation Fears

(MoneyWatch)  The Federal Reserve is signaling that deflation, one of the great economic fears of the last year, is no longer a threat. That seems to indicate the Fed now feels confident that we won't have another depression along the lines of the downturn in the 1930s.

You'd have to look hard for the Fed's change of view. In an April 29 release, the Federal Open Market Committee warned that "some risk of inflation could persist for a time below rates that best foster economic growth and price stability in the longer term." The phrase "below rates" is Fed-speak for deflation. That warning, however, is no longer mentioned in the Fed's new policy statement that was just issued this week. End of worry.

The new Fed statement was generally upbeat. In addition to dispensing with deflation, it also said another potential scourge, inflation, is unlikely anytime soon. Several pundits have warned that government borrowing to finance budget deficits could cause high inflation. While energy and commodity prices have risen lately, the Fed said, "substantial resource slack is likely to dampen cost pressures" and inflation will remain "subdued for some time."

In sum, the Fed said, "the pace of economic contraction is slowing." The Fed left interest rates unchanged at between zero and 0.25 percent. But it also didn't indicate any planned increased purchases of Treasury bonds, an indication that the Fed is willing to allow interest rates to rise slightly. In the last couple of weeks, rates on mortgages have crept higher, which has had a dampening effect on people getting new mortgages, but the Fed said it was sticking to its original plan of buying $1.25 million of mortgage-backed securities and $300 billion of Treasury bonds by the end of the year.

Because of higher rates and a glut of unsold homes, the housing picture is still gloomy. New home sales fell 0.6 percent in May to 342,000, according to the Commerce Department. That was down 32.8 percent from May 2008. While many builders have cut both prices and new home construction, they're still competing against thousands of foreclosed homes that clog the market, selling at huge discounts. The Commerce Department said it would take more than 10 months to sell all the new homes on the market.

Reflecting the Fed's slightly upbeat outlook, there was some good news on the manufacturing front. Durable goods orders for things like washing machines and refrigerators increased 1.8 percent in May for the second month in a row, according to the Commerce Department. That was way ahead of economists' expectations of a drop 0.9 percent, according to Bloomberg.

Demand for non-defense capital goods excluding aircraft, which many economists use as a measure of future business investment, actually climbed 4.8 percent, the most since 2004. "The increase in orders for capital equipment is the most encouraging sign to date that the severe downturn in corporate investment spending is quickly moderating," Michael Feroli, an economist at J.P. Morgan, wrote in a note to investors.

In another positive sign, the Organization of Economic Cooperation and Development, which represents the world's 30 largest industrial nations, said in its semiannual economic report that it expects member countries will grow 0.7 percent in 2010 after falling 4.1 percent this year. An earlier OECD estimate had predicted a small decline in 2010.

"It looks as if the worst scenario has been avoided and that OECD economies are now nearing the bottom," said OECD economist Jorgen Elmeskov. "Even if the subsequent recovery may be slow, such an outcome is a major achievement of economic policy."