NCPA - National Center for Policy Analysis

FED Studies Prospects for Deflation

November 6, 2002

How would the Federal Reserve Board respond if prices suddenly reversed course and started falling? The board has been looking into possible responses. Deflation is dangerous because it makes it difficult to boost the economy by cutting interest rates, and because it makes debt -- now at a post-war high in the U.S. -- harder to repay.

The prospects for deflation do not seem as outlandish now as they once appeared to be.

  • Prices of consumer goods -- as opposed to services -- are falling for the first time since 1960.
  • By the Fed's preferred measure, overall inflation was just 1.8 percent in the year through August.
  • Fed policy makers have cut short-term interest rates to a 41-year low of 1.75 percent -- and they could drop as low as 1.25 percent.
  • The International Monetary Fund projects that inflation in industrialized countries this year will hit 1.4 percent -- the lowest level in 40 years.

Falling prices need not be worrisome when they are the result of greater productivity. But if the cause is declining demand -- as it was during the Great Depression of the early 1930s -- the results can be devastating, particularly when combined with high levels of debt such as we have today.

However, few economists see deflation as likely, in part because inflation has been low and stable for years. As long as businesses and consumers expect that to continue, and set prices and wages accordingly, deflations risks are diminished. Nobel winner Milton Friedman says deflation is "not a serious prospect." If it occurred, however, he has a simple solution: "Print money."

Source: Greg Ip, "Inside the Fed, Deflation Draws a Closer Look," Wall Street Journal, November 6, 2002.

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