Bernanke and the peril of deflation

The Federal Reserve recently acknowledged that the risk of deflation in the US, though still small, has grown. Is policy correctly aligned to confront this risk? Not yet.

With Japan as an example, nobody should need reminding that deflation is a uniquely dangerous prospect - but here is a refresher. Persistently falling prices increase the inflation-adjusted burden of debt. Insupportable debts are the core of the US economy's difficulties. If that burden grows even heavier because of falling prices, the contractionary forces will strengthen. The economy will slow further, the deflationary pressure will increase again, debts will become more burdensome, and so on. Since interest rates cannot fall to less than zero, monetary policy cannot follow inflation all the way down. This makes the deflationary circle difficult to break. Nothing is more important than preventing the economy from toppling into it.

Prices in the US fell in October by 1 per cent, the biggest such fall for 60 years. That was an urgent warning - though it does not mean that deflation has arrived just yet. Prices (excluding food and energy) are 2.2 per cent higher than a year ago. Expectations of inflation remain positive, which is crucial since expectations of inflation tend to be self-fulfilling. It would take a stunning and prolonged recession to drive inflation expectations negative, thus pushing the economy all the way over the deflationary edge. But a stunning and prolonged recession may be exactly what the US faces. At the moment, each new economic indicator shows a shocking rate of contraction.

In Ben Bernanke, the Fed has a chief who understands deflation's causes and cures as well as anybody: the subject was one of his specialities as an academic. Since joining the Fed he has given speeches on unconventional tools of monetary policy that can be used when short-term interest rates have been cut virtually to zero: new facilities to improve liquidity; commitments to keep short rates low; "quantitative easing" (expanding the Fed's balance sheet, thus supplying reserves to the banking system), and other measures. Many of these unorthodox tools have already been deployed. What more needs to be done?

In a speech in 2002, Mr Bernanke pointed out that "the effectiveness of anti-deflation policy could be significantly enhanced by co-operation between the monetary and fiscal authorities". A big fiscal stimulus, financed by Fed purchases of government debt, would be "essentially equivalent to Milton Friedman's famous 'helicopter drop' of money", he said.

For a prudent central banker, unalloyed monetising of the deficit is the last taboo - this, after all, is Zimbabwe's idea of monetary policy. But in this remarkably perilous situation, the prohibition must be set aside, and better that this should happen before deflation has set in and entrenched itself. Do it now, and make it plain you are doing it. If it makes analysts and commentators complain about the inflationary consequences, so much the better: the aim is partly to buoy expectations of inflation.

Barack Obama is preparing a big new stimulus. Figures of between $500bn and $700bn are being discussed. The sooner it can be enacted the better. To ensure the biggest effect on demand it would be best to tilt towards temporary spending rather than tax cuts, with one exception. Too little has been done to curb mortgage foreclosures, which continue to press down on house prices. The prospects for a broader recovery are dim until that changes. Three things are needed. First, public money should be found to support the proposal by Sheila Bair, head of the Federal Deposit Insurance Corporation, to modify more loans in delinquency. Second, the bankruptcy code must be changed to allow mortgage loans to be restructured by bankruptcy courts - an urgent task for Congress. Third, to boost demand for housing, downpayments should get temporary tax relief (as suggested by Allan Meltzer on FT.com on November 11).

To make subsequent fiscal restraint easier, the spending should be either tied to the cycle (unemployment assistance, for example) or once and for all (infrastructure projects, for instance). And, something I imagined I would never propose, it should be explicitly financed by printing money.

The efficacy of a huge combined fiscal and monetary stimulus turns on perceptions: to repeat, influencing expectations is the key. This puts a premium on speed and on clear communication, and raises a question about Mr Obama's appointments. He has put together a superbly talented team, but with so many strong-willed members one wonders who is in charge. Lawrence Summers at the National Economic Council? Timothy Geithner at the Treasury? This potentially unstable new duumvirate immediately aroused speculation about Mr Bernanke's future influence and likely tenure at the Fed - an unhelpful development. If this were not complicated enough, next came the announcement of a new Economic Recovery Advisory Board, headed by none other than Paul Volcker.

Mr Obama has emphasised that he will be in command. He better had be. Yet it remains to be seen whether he can control this group of eminences and communicate his policy with sufficient authority. Unlike John McCain, Mr Obama never boasted of his ignorance of economics but the new president is no more master of these issues than his former rival. Boldness seldom comes out of committee, nor does forthright explanation. He is going to need a chief of economic policy - and it would be good if that person, and everybody else, knew who it was.

clive.crook@ft.com