Greenspan's Deflation
Is the U.S. destined to follow Japan down the deflation rabbit hole? Not if Alan Greenspan and his associates move to pump liquidity into the system at next week's Federal Open Market Committee meeting. Providing enough extra monetary liquidity by a reduction in the target Fed funds rate from 1.75% to 1.25% would enhance pricing power and ward off what is now a mild case of deflation.</br></br>Complacency is deflation's friend. The cure for deflation lies in aggressively changing the stance of monetary policy. For years the Bank of Japan underestimated the needed infusion of liquidity and chose to fall behind by substituting a prolonged cut in overnight interest rates to zero and then complained that they had done all they could do. Not so. The BoJ could and can use a price-level proxy, such as the yen/dollar exchange rate, as a guide to buying more central-bank assets. Their choice to proclaim zero-rate helplessness was a political not a monetary policy decision.</br></br>Mr. Greenspan and the FOMC should learn from the BoJ's mistakes. But before they can cure the disease, they must first diagnose it. Incredibly, the Fed seems more concerned with the potential dangers of inflation than the current effects of deflation. Inflation is easy to recognize partly because we have had so much experience with periods in which the purchasing power of our money has declined. The essence of inflation is that business leaders believe they have pricing power. They expect households to accept another price increase as they always have done. Both business and household decision-makers expect that the central bank will provide the liquidity to keep up the growth of output of goods.</br></br>The essence of deflation is that business leaders know they do not have pricing power. Yet in the first several years that business leaders experience a lack of pricing power they are apt to view the condition as temporary -- they believe that it is the result of a recession or cyclical downturn. They expect that pricing power will return with a recovery.</br></br>This is precisely what's happening in the U.S economy today. Nevertheless, Mr. Greenspan and the patient crowd at the Fed remain unconvinced. It is easy for them to point out recent increases in the cost of living of between 1% and 2% (as measured by consumer price index) as evidence of inflation, not deflation. What they fail to realize, however, is that the cost of living can actually rise in a period of mild deflation.