Deflation FINALLY Becoming Focus of Fed Discourse

A string of developments has altered the sentiment within the central bank,

leading Fed policy makers to stop worrying for the moment about the increasingly remote prospect of inflation.

Instead, they are increasingly focused on the potential for the economy to slip into a deflationary spiral of declining demand, prices and wages.

Not since 2003 has the prospect of deflation been taken so seriously at the Fed,

A string of developments has altered the sentiment within the central bank,

leading Fed policy makers to stop worrying for the moment about the increasingly remote prospect of inflation.

Instead, they are increasingly focused on the potential for the economy to slip into a deflationary spiral of declining demand, prices and wages.

Not since 2003 has the prospect of deflation been taken so seriously at the Fed,

and not since the 2008 financial crisis have the markets been looking so closely to it for guidance.

With Congress unwilling to embark on substantial new stimulus spending,

the Fed has the only tools likely to be employed anytime soon in response to the economic warning signs.

The Fed’s chairman, Ben S. Bernanke, and other officials believe that the Fed, having lowered interest rates all the way to zero in 2008, still has the ability to avoid deflation.

But they are also concerned that any new dose of monetary medicine could carry unintended side effects,

making it harder to normalize policy in the future.

Complicating matters, a vocal minority of Fed officials is skeptical that deflation —

a spiral of falling wages and prices, which Japan’s economy has experienced since the 1990s — is even a worry.

But Jan Hatzius, chief United States economist for Goldman Sachs,

has predicted the Fed would begin a new round of asset purchases —

which could include at least $1 trillion worth of Treasury securities —

late this year or early next year.

He has also revised down his forecast for the growth of gross domestic product in 2011 to 1.9 percent from 2.4 percent.

And he has predicted that unemployment would hit 10 percent in the second quarter of next year.

Among the voting members of the central bank’s policy-setting Federal Open Market Committee this year,

the presidents of the Fed’s Boston and St. Louis district banks have warned recently about the threat of deflation,

while the Kansas City bank president is known for his view that inflation, the Fed’s traditional enemy, remains the greatest threat.

In March, the Fed completed its purchase of $1.25 trillion in mortgage-backed securities.

A decision to reinvest the bond proceeds in other mortgage-related securities, or in Treasuries, would be largely symbolic

but carry great weight, as it would signal concern about the economy,

and also make clear that an “exit strategy” from easy monetary policy was not imminent.

But Laurence H. Meyer, a former Fed governor, said the committee should take into account not just the probability of various outcomes,

but the potential damage associated with each of them, according to this overlooked article from the New York Times.

The key point, however, is that the focus of discourse is finally becoming realistic –

whatever the Tea Party Republicans or other so-called “deficit hawks” may be braying.