Too close to the edge -- of deflation

Larry Kudlow
Posted: May 08, 2003 12:00 AM

Inflation causes prices to rise because the Federal Reserve creates more money than the economy needs. Conversely deflation results in falling prices because the central bank creates a shortage of money.

So, if the most important goal of monetary policy is domestic price stability -- i.e., neither the risk of inflation nor deflation -- then the Federal Reserve should provide additional liquidity for the economy.

While some reflation is occurring today, it's not entirely certain that deflation has completely passed us by. Business prices are now rising at about 1 percent. This is not much of a comfort zone since the way government measures prices -- in particular, the prices of services -- is imperfect at best.

Durable goods prices, however, have been falling steadily by nearly 3 percent. This is exactly what Alan Greenspan and the Federal Reserve should be concerned about. The price category known as "furniture and household equipment" (think appliances) is deflating at about a 5 percent rate. The "other durable goods" category is deflating by about 1 percent. Motor vehicles and parts are falling by slightly more than 1 percent.

Other more widely followed price indexes, such as those for personal spending, producer prices, and consumer prices, are rising by about 1 percent to 1.5 percent on balance. But again, that's pretty close to the edge of deflation when measurement uncertainties are taken into account.

Treasury yields provide more evidence that we're not yet out of the deflationary woods. If deflation expectations have truly been eliminated, and growth expectations have taken over, then the difference -- or the "fed spread" -- between the interest rate attached to the 2-year Treasury note and the federal funds interest rate would be much wider today.

And if growth expectations and pricing power have recovered sufficiently, then Treasury rates across the maturity spectrum would be rising noticeably. But that has not yet happened.

During the investment boom of the second half of the '90s, interest on the 10-year Treasury note averaged 6 percent, in step with growth of real gross domestic product. So, today's unusually low 4 percent yield for the bellwether Treasury should revert back to a higher rate that is characteristic of stronger economic performance.

In 1973, when I was a young pup just starting out as an open-market-operations economic analyst at the Federal Reserve Bank of New York, deflationary price readings would have been unthinkable. At the time, double-digit inflation expectations were embedded in every day American economic life, as symbolized by the collapse of the U.S. dollar and the skyrocketing advance of gold, commodity and related hard-asset prices.

Then, as Paul Volcker and his successor Alan Greenspan gradually and continuously restrained money creation by the Fed, inflation anticipations were finally reversed. But now the question is, have policymakers unwittingly launched a new era of deflationary concerns?

Supply-siders like myself believe that it must pay adequately, after-tax, to work and invest more. Given what has happened to the stock market in recent years, it will have to pay much more, after-tax, to induce substantial new investment. That is why the president's tax package makes sense. By significantly reducing taxes on dividends, income (including small-business income) and capital gains, the Bush plan will substantially lower the federal tax bite on capital -- which will go a long way toward boosting real investment returns in the economy.

But investment returns also depend on business pricing power and profits. While it would be futile to pursue a monetary policy that simplistically seeks to inflate business prices, it is nonetheless important to avoid profit-wrecking deflation.

During the early part of 2002, the Federal Reserve loosened up quite a bit in an attempt to aid an economy that was still reeling from the events of 9-11. By temporarily decontrolling its policy of targeting the overnight interest rate, it opened the door to massive money-adding operations that contributed to 4 percent GDP growth and an S&P 500 that hit 1,150. That's just what we need to happen now.

In order to blunt business worries over the threat of long-run price declines, and to open wide the door to steadier prices, production, profits and investment returns, the Fed should take out an insurance policy by stepping up its money-adding operations. Today. The central bank should let the market determine interest rates. Then Greenspan & Co. should add new cash to the economy until prices and market rates tell us that deflationary expectations have been eradicated.