US Markets Fear Damaging Deflation

November 9, 2008

With the threat of spiraling commodity prices, the Federal Reserve remains vigilant to protect the US economy and prevent the inflation rates from dropping below zero. The real factor in any preventative measures is the risk of serious deflation and its damaging consequences to the economy.

The Federal Reserve has had its hands full providing different ways to mitigate the effects of the credit crisis. Interest rates have been lowered to 1.5%. Over $1 trillion has been injected into the US financial markets. These actions have literally doubled the Fed’s balance sheet and US currency is on the rise.

Additionally, the Fed’s actions to prevent deflation may cause price pressures, particularly in the wake of any further slashes in interest rates. Regardless of any potential consequences, most see the program as a guarantee to insure the economy.

Briefly defined, deflation is a long-term and widespread price decline that causes business and consumers to cut back their spending in order to wait for lower prices. There have already been some indicators of a developing deflation period.

First, worries about the possibility of global recession have directly affected oil prices causing a serious drop in the price per barrel from its July peak of $147 to around $70 a barrel. Second, expected inflation rates as they are measured by yield spread between ten-year Treasury bonds and inflation index bonds. Specifically, the spread has dropped to about 90 basis points from a high 270 points in just a three-month period. It is no surprise that bond market analysts are more concerned about deflation than inflation.

Legislators note that there should be no real concern about serious deflation take hold as long as the decline in commodity prices does not spread to areas of core inflation; this does not include food costs and energy prices. If the economy remains anemic and the core prices are drawn downwards toward a headline inflation level near zero, the central banking institutions in the US will have real cause for concern.

At the same time, if deflation rises started rising, the Federal Reserve would face some difficulties in discerning the right moment to remove its stimulus funds, to keep things under control.

Related Entries