The Federal Reserve will do whatever it takes to ensure the US does not fall into a deflation trap, its vice-chairman said on Wednesday, as US stocks fell to the lowest level of the financial crisis.
The comments by Don Kohn will reinforce expectations that the US central bank may cut interest rates again by as much as 50 basis points from the current level of 1 per cent in December.
The S&P 500 fell 6.1 per cent to 806.58, a five-and-a-half-year low, as bank stocks plunged and investors sought the safety of government debt. The yield on the two-year Treasury note fell to its lowest level since June 2003 - 1.06 per cent.
Mr Kohn’s remarks came as minutes revealed that the Fed believed the US economy was in the midst of an economic contraction that would continue into next year.
The minutes said “participants generally expected the economy to contract moderately in the second half of 2008 and the first half of 2009”.
Fed officials sharply increased their unemployment forecasts for late 2009, taking the central range of their estimates to between 7.1 per cent and 7.6 per cent – almost two percentage points higher than they were expecting in June.
The discussion in the minutes confirms the sense that the US economy suffered a financial heart attack in September and October as the crisis in the markets escalated.
Growth was weaker across the board, with a “negative spiral in which financial strains lead to weaker spending, which in turn lead to higher loans losses and a further deterioration in financial conditions”.
The minutes show Fed officials expect inflation to decline to levels consistent with price stability – but not too low, with most of them still seeing inflation next year in the range of 1.3 per cent to 2 per cent.
However, for the first time in many months, Fed officials stopped worrying that inflation could turn out to be higher than they forecast, and some worried that it could end up too low.
These concerns were fuelled on Wednesday by news that consumer prices fell 1 per cent in October, with core inflation down 0.1 per cent – its first decline since December 1982.
The Fed vice-chairman stressed he did not believe deflation was the most likely outcome for the US economy, but was a “less remote” possibility than he previously thought.
“Some people have argued that we should save our ammunition, that interest rate cuts aren’t effective,’’ Mr Kohn said. “I think that were we to see this possibility, that we should be very aggressive with our monetary policy, as aggressive as we can be.”
Much of the fall in headline inflation came from energy prices dropping 8.6 per cent. On Wednesday crude oil fell to a $53.30 a barrel, its lowest since January 2007.
The main surprise from the CPI report was the slide in the core rate, which excludes food and energy prices. It was the first negative core reading since December 1982.
Treasury inflation-protected securities indicated that investors expects deflation, though Fed officials expressed concerns that prices were being distorted by a lack of liquidity. The five-year break-even rate, which provides an expectation of future inflation, suggested that investors expected annualised inflation to be minus 0.70 per cent over the next five years.
“The general thrust of the (consumer prices) report supports our call that disinflation is now a reality and deflation will be the next major risk to financial markets,” said Steven Ricchiuto, chief economist at Mizuho Securities.
