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Deflation is new Public Enemy No.1

January 05, 2009 | “MarketWatch"

Top officials from Fed and ECB vow to keep it contained

SAN FRANCISCO (MarketWatch) -- Deflation, the steadily falling prices that are a byproduct of the virulent global recession and financial-market weakness, has emerged as a top danger for monetary policy markets in the U.S. and Europe, top central bankers made clear Sunday.

In separate comments, Lucas Papademos, the number-two official at the European Central Bank, and Janet Yellen, president of the San Francisco Federal Reserve Bank, and one of the most influential officials at the Fed, said that they would quickly seek to contain the danger of deflation if it emerges in coming months.

Their remarks came at he American Economics Association convention.
Yellen said the U.S. faces a clear risk of deflation: "The odds are high that over the next few years, inflation will decline below desirable levels."

To keep falling prices from becoming entrenched, the Fed would have to make it clear to the financial markets that such an outcome is unacceptable.

"I am optimistic that, by clearly communicating the Fed's commitment to low and stable inflation and by backing that commitment up with determined policy actions should the need arise, any deflationary pressures caused by the weak economy can be contained," Yellen said.

Papademos said the risk of deflation is a more distant threat to Europe.
"We will do what is necessary, in terms of the timing and in terms of the size (of interest rate policy action) to ensure that price stability is preserved," Papademos told reporters.

"Inflation will not be allowed to fall significantly below 2% for a protracted period of time, over the medium term, which we do not expect on the basis of our present analysis," he said.

It was only this past summer that central bankers were focused on the risk of higher prices, or inflation.

But the financial market collapse of mid-September radically changed the outlook.
One effect of deflation is that consumers delay purchases in order to wait for better bargains.

But a more pernicious threat, especially for the U.S., is that it would make household debt burdens heavier.

Japan has become ensnared in a deflation cycle that has cut the growth rate to a snail's pace.

Prominent economists at the convention were not of one mind about whether an outbreak of deflation was likely.

Some say the risk is remote.

But many agree with Barry Eichengreen, a professor at the University of California at Berkeley, who called deflation "a very serious danger."
Central bank officials are "scared, if not scared witless" about the specter of deflation, he said.

The good news is that, because the Fed is so vigilant, the U.S. should be able to avert it, he said.

Fed officials would use the new unconventional monetary policy measures to simply buy up "anything whose price shows signs of going down," he said.
Eichengreen was less sanguine about Europe's chances of avoiding deflation.
"There is more of a danger there," he said.

The ECB is miles behind the Fed in cutting short-term interest rates and Europe does not have a unified fiscal policy authority, he noted.

By Greg Robb, MarketWatch


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