How would the Federal Reserve Board (the Fed) 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.
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 the U.S. has 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, deflation risks are diminished. Nobel prize-winning economist 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.
For text (WSJ subscribers) www.wsj.com
For more on Federal Reserve Monetary Policy http://www.ncpa.org/iss.eco
FMF Policy Bulletin\12 November 2002
