FED FOCUS-New phase of crisis revives US deflation concerns

By Pedro Nicolaci da Costa

WASHINGTON, May 19 (BestGrowthStock) – Ben Bernanke is again being
confronted with hints that his sworn enemy, deflation, might be
making a comeback. This time though, the Fed chairman’s policy
arsenal looks sorely depleted.

Nearly eight years after declaring war on deflation in a
speech that earned him the nickname “Helicopter Ben,” the head
of the U.S. Federal Reserve is again confronting the threat of
a corrosive cycle of falling prices.

One of the U.S. central bank’s favored inflation measures,
the core consumer price index, rose just 0.9 percent in the
year to April, the smallest gain since 1966. Most Fed officials
would like to see that number closer to 2 percent.

“The recent trend in inflation has been swiftly to the
downside,” said Eric Green, chief U.S. rates strategist at TD
Securities in New York. “All measures of inflation are
decelerating.”

In 2002, Bernanke made a vehement case that central banks
were not powerless to stimulate the economy even when official
interest rates were pushed near zero. The financial crisis
forced him to put those ideas into action.

But the unorthodox measures the Fed has taken have come at
a high cost, including greater political interference with
monetary affairs and, ironically, heightened inflation fears
due to the sharp increase in the money supply.

As part of its emergency efforts, the Fed not only slashed
interest rates near zero but also bought about $1.7 trillion of
mortgage and Treasury bonds, expanding total outstanding credit
to the banking system to more than $2.3 trillion.

Having acted so aggressively, the Fed’s room for further
maneuver if needed is constrained.

BY WORD AND SWORD

Of course, a single month’s decline does not a trend make.
Part of the easing inflation trend has been driven by a
decrease in housing costs that is expected to bottom out in the
next few months as the downtrodden sector stabilizes.

Yet a sharp recent retreat in commodity prices, which has
seen oil prices plunge some $20 in just three weeks to around
$68, suggests the disinflation trend is likely to persist.

Market barometers show the concerns gaining ground among
investors. On Thursday, the differential between yields on
benchmark U.S. Treasury notes and inflation-protected debt fell
to its lowest since October, indicating many see deflation as a
real possibility.

And with Europe mired in a worsening debt crisis that
threatens a flashback to the credit-impaired days of late 2008,
the possibility of an unwelcome decline in prices begs the
question of what Fed officials might do if deflation sets in.

Deflation, a broad and persistent drop in prices throughout
the economy, can eat away at an economy by encouraging
consumers to defer purchases and raising the inflation-adjusted
burden of debts, fueling further economic weakness in a
self-feeding downward spiral.

“What is going on in Greece, and the Club Med countries in
general, must be seen as a significant deflationary shock —
underscored by the fact that U.S. dollars are in such huge
demand as was the case after the Lehman collapse,” said David
Rosenberg, chief economist at Gluskin Sheff.

EMPTIER TOOLKIT

In his 2002 speech, entitled “Deflation: Making Sure It
Doesn’t Happen Here,” Bernanke outlined what the Fed could do
if faced with a deflationary .

But the Fed has already put into play a number of the ideas
Bernanke discussed, including buying up government and private
debts and committing to holding short-term rates low for a long
time to pull down long-term borrowing costs.

Now, its room for maneuver is limited. The Fed’s relatively
modest purchase of $300 billion in longer-term Treasury
securities sparked fears the central bank was “monetizing”
government deficits by printing money.

Another possible approach would be to actively raise the
Fed’s implied inflation target of about 1.5 percent to 2
percent. This has been advocated by some prominent economists,
but does not hold great favor among members of the Fed’s
Washington-based board, who fear such a move could unleash an
inflation that might be hard to stop.

John Canally, economist for LPL Financial, said that while
inflation expectations, which the Fed sees as a harbinger of
inflation itself, are relatively stable, anxiety is showing up
in certain places. Just look at the price of gold, he says. The
price of the yellow metal, seen as an inflation hedge, has
continued to hit new records despite the prospect of renewed
economic weakness.

Stock Market Investing
(Reporting by Pedro Nicolaci da Costa; Editing by Kenneth
Barry)

FED FOCUS-New phase of crisis revives US deflation concerns