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The Fed Fears Deflation More Than Inflation

In his interesting post, Scott Sumner argues that deflation is more likely than inflation, and that if it occurred, it would damage the economy by effectively raising labor costs to firms, forcing them to lay off more people and worsening our unemployment problems. In contrast, I view deflation as less likely than inflation -- in part because deflation would be so damaging that the Federal Reserve cannot afford to allow it to occur, and would adjust its policy accordingly.

But I don't think deflation would be damaging in the way Sumner sees it. The job losses would not be the worst effect. Recent surveys show that wages are in fact adjusting to the economic crisis, as more and more companies decide that it's better to temporarily freeze wages or cut salaries rather than lay people off.

The more substantial danger of deflation is that it would further impair the balance sheets of banks by lowering housing prices and the value of mortgage-backed assets. Deflation would result in a greater number of homeowners with negative equity, leading to even more foreclosures.

The risk to the financial system
Even worse, significant deflation could impair the balance sheet of the Fed, which has taken on risky assets in an unprecedented fashion in the last nine months.

Deflation could weaken the Fed's balance sheet by lowering the value of its assets without reducing the value of its liabilities. While this scenario is unlikely, if it did happen, there would be two possible ways to deal with it, neither of which is problem-free. Either the Fed would induce inflation by expanding the money supply even more than they have already, a move which could erode its credibility. Or the Treasury would be forced to backstop the Fed and provide it with new assets, which would raise questions about the Fed's independence and might be politically difficult to boot.

At the end of the day, Federal Reserve policy has a large impact on whether deflation or inflation occurs, and given that the costs of deflation outweigh those of modest inflation, I expect the Fed will adjust policy to prevent significant deflation from occurring. The Fed's moves have successfully done this over the last nine months, and would continue to do it if needed.

Little sign of deflation
Last fall, financial markets were panicked and deflation fears ran high, leaving some people worried about the possibility of "self-fulfilling deflation." This is when consumers postpone purchases as they anticipate prices dropping in the future, an anticipation that leads to deflation.

But there is little research to support the idea of self-fulfilling deflation. Deflation fears are much lower now than just a few months ago. The latest data shows consumer and producer prices are little changed this year. There are signs that our current crisis, while still severe, may turn around faster than many had anticipated. The stock market is up about 35 percent since March, and job loss is slowing. The banking system has much improved its reserves and liquidity, thanks to unprecedented actions by the Fed. Taken together, these data suggest that there is little sign of deflation now.

Is inflation inevitable?
This leaves us with the question that so many economists and financial market observers are asking, which is: Will the enormous increase in bank reserves ultimately lead to inflation? Inflation is a potential risk, given the Fed's recent moves, but it can certainly be averted if the Fed can reverse the positions that it took over the last nine months. Though the Fed increased the money supply, we haven't had inflation yet because there has been a remarkable increase in the demand for cash by banks and others since the financial crisis began. But this demand for liquidity won't last forever. At some point, the banks will release the cash reserves into the economy by making loans, and the money supply will grow.

If the Fed can reverse its recent positions quickly enough, then inflation would be halted. In fact, some of the Fed's positions are already being reduced as the health of the banking system improves. Can the Fed do it quickly enough? Yes, with one possible caveat: it might result in higher interest rates if the Fed has to move very quickly.

Over the past 25 years, the Fed has had an impressive record of keeping inflation low and stable. The Fed has performed admirably during our current crisis, preventing deflation and stabilizing the banking system, and I expect they will continue to do so as we move forward. And this means no deflation.

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