With inflation low and the recovery waning, a growing chorus of analysts is beginning to suspect that U.S. policymakers aren't doing enough to head off deflation.
U.S. producer prices fell for a third straight month in June, sliding 0.5%. That follows declines of 0.1% in May and 0.3% in April. Core inflation, which excludes food and energy costs, managed only a 0.1% increase for the month, and is up just 1.1% in the past 12 months. The U.S. Federal Reserve's preferred target for inflation is 2%.
Meanwhile a high rate of unemployment continues to jeopardize the U.S. recovery, and economists fear that a significant drop in economic growth could tip the scales toward a deflationary spiral.
"If you were to look at the balance of risks and what we could do about those risks, the risk from a downside shock I would view as more of a problem than the risk of an upside shock of inflation or the economy overall," Federal Reserve Bank of Boston President Eric Rosengren said in an interview with The Wall Street Journal.
"The core inflation rate is right around 1%," he said. "Given the amount of substantial excess capacity that we have in the economy, there is some risk of further disinflation. And I would say the risk of deflation has gone up and is more of a risk than I would like to see at this point."
Rosengren's comments are evidence of a growing divide among members of the Federal Open Market Committee (FOMC). The Fed, under pressure to pursue an exit strategy, has already taken steps to reign in its balance sheet by abandoning its policy of quantitative easing and ending its bond purchasing program. And most analysts believe Federal Reserve Chairman Ben S. Bernanke will stay on the sidelines, barring any economic collapse.
The FOMC said in the minutes of its June meeting that the outlook for the U.S. economy had "softened somewhat," but that it would only consider further stimulus measures "if the outlook were to worsen appreciably."
"Fed officials would have to see the economy in a free fall," before resuming bond purchases, Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. (NYSE: JPM) told Bloomberg. "The economy is not in a free fall. They also see the benefits of additional asset purchases as not that great."
The central bank more than doubled its balance sheet to $2.3 trillion during the financial crisis, as it bought up mortgage bonds and Treasury debt to keep long-term interest rates low. And while those purchases may have helped lower mortgage rates, they did little to broaden credit. Consumer borrowing decreased by $9.1 billion in May after falling by $14.9 billion in April.
However, the Fed's minutes also acknowledged the threat of deflation for the first time in a year.
"Several participants noted that a continuation of lower-than-expected inflation and high unemployment could eventually lead to a downward movement in inflation expectations that would reinforce disinflationary pressure," the minutes read. "By contrast, a few participants noted the possibility that a potentially unsustainable fiscal position and the size of the Federal Reserve's balance sheet could boost inflation expectations and actual inflation over time."
The benchmark Federal Funds rate remains at a historically low range of 0-0.25%. But critics contend that Bernanke could do more to stave off deflation either by resuming purchases of assets or by being more explicit about its intentions to keep interest rates low.
And Rosengren, of the Federal Reserve Bank of Boston, noted that the central bank currently has more tools at its disposal to combat inflation than it does deflation.
"We have plenty of tools to tighten up if it turns out the economy grows faster and inflation becomes more of a concern. But it is a little uncertain how effective our tools are once the economy gets into a deflationary environment," he told The Journal. "The experience of Japan is sobering. They've spent a decade and a half dealing with an economy that has had falling prices and despite a variety of monetary and fiscal actions taken are still facing a deflation problem."
Meanwhile, the U.S. economy is trembling under the weight of high unemployment, low consumer spending, and a public and political push for fiscal conservativism. Retail sales fell 0.5% in June after tumbling 1.1% in May, according to the Commerce Department. And the Institute for Supply Management's index of non-manufacturing businesses – which comprise 90% of the economy – fell to a four-month low.
The Fed's minutes revealed the central bank has lowered its economic forecast for U.S. growth to a range of 3.0%-3.5% from 3.2%-3.7%, and openly acknowledged the threat being posed by unemployment. The Fed said the U.S. jobless rate, currently at 9.3%, would remain above 7% for at least the next two years.
"The data over the last couple of months have given pause," Former Federal Reserve Vice Chairman Alan Blinder told Bloomberg Television. "Housing has underperformed. The big, big thing that has happened in the last couple of months is a very sharp slowdown in the number of private-sector jobs."
Should such "pessimistic" data be "portents of what's coming, then the Fed needs to be prepared to go back into quantitative easing in a big way," he added.
The federal government should do more to preserve the recovery as well, according to Blinder.
"I think we need a little bit more out of Washington," he said. "There is still room for some more fiscal stimulus. I would like to see it very targeted to jobs creation. That is the real problem we are having now."
Congress last month failed to extend unemployment benefits, leaving some 2 million people without unemployment aid. That figure could grow to 3.3 million by the end of the month if a deal isn't reached.
"We should be concerned about downside risk. I'm certainly in the camp where I'm worried about downside risks and policy needs to be thinking about contingencies," said Rosengren. "Part of central banking is to think about what the risks in both directions are and what the policy response would need to be."
News and Related Story Links:
- Wall Street Journal:
Boston Fed's Rosengren: Growth Slowing, Deflation Is Emerging Risk
- Money Morning:
Misguided Policy Paving the Way for a Double-Dip Recession
Fed Unemployment Forecast Fails to Bring Stimulus