The Fed has stated that it is not worried that low interest rates and an economic recovery will cause inflation. Adjustments in economic policy and control of the money supply will prevent that. Deflation is another matter.
Japanese consumer prices dropped 1.7% in June. Reuters claims that this is a record level of deflation in the large Asian economy. Today, EU officials announced that consumer prices in that region fell .6% during last month.
If the pattern persists into the fall and the US begins to post similar drops in consumer prices, the global economy will face full-blown deflation in the fourth quarter. That will undermine whatever recovery which is mounting in developed nations. An increase in unemployment will only slacken demand further.
One of the hallmarks of deflationary periods is a lack of money supply and credit. Banks are pulling credit cards from consumers at record rates. Businesses, particularly smaller ones, cannot get loans or lines of credit. Financial firms are simply too concerned about defaults. Slow consumer spending and businesses without access to capital will only make unemployment worse.
The most likely way that the federal government currently has to combat a long period of deflation is the $787 billion stimulus package. The programs in the package have been criticized for not bearing fruit. The Administration has said they were not meant to have much success until next year.
The trouble with waiting until next year is that unemployment may be over 10% and heading to 11%. Even a significant jolt from government investment and tax programs may not be able to offset the huge drop in consumer demand that high joblessness will exacerbate. A deflationary cycle could be in full force by the end of this year.
Efforts to combat deflation will not be helped if GDP does not grow in Q3 and improve in Q4 as expected. The Fed may be unconcerned about inflation, but it is casting its eyes in the wrong direction.
Douglas A. McIntyre
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