NCPA - National Center for Policy Analysis

Interest Rate Fall May Signal Mild Deflation

January 12, 1998

To consumers who still see prices for food and clothing rising steadily, any discussion of deflation must seem ridiculous. But many people in financial markets have come to believe that deflation -- falling prices -- is now a greater risk than inflation.

The prices consumers pay are the result of a long chain of commodity and producer prices, many of which are trending downward. Thus there is a good possibility that consumer prices too may fall in the future.

Prices for financial assets may also indicate the future direction of consumer prices. Among the most closely watched is the yield curve for Treasury securities.

  • Normally, a yield curve slopes upward, with interest rates going up as maturities rise.
  • Thus interest rates on 30-year Treasury bonds will normally be significantly higher than on three-month Treasury bills.
  • When the yield curve becomes inverted, with short-term rates rising above long-term rates, this is frequently an indicator of an economic slowdown.

The yield curve has lately become very flat, with long-term interest rates only slightly above short-term rates (see figure), because long-term rates have fallen sharply as inflationary expectations have diminished.

Federal Reserve Board Chairman Alan Greenspan discussed the possibility of a mild deflation on January 3, saying a mild deflation can be absorbed by the economy without serious disruption. Nevertheless, it is clear he believes price stability should be the goal of monetary policy.

Traders in financial markets took Greenspan's comments favorably, causing the yield on Treasury's 30-year bond to fall to an all-time low. They also feel confident that if true deflation does emerge, the Fed will keep it in check.

Source: Bruce Bartlett (senior fellow, National Center for Policy Analysis), January 12, 1998.

 

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