Bernanke's Fight Against Deflation

Comparisons between the United States today and Japan in the early 1990s just keep growing. The Japanese call that period the "Lost Decade," as it was marked by anemic growth, plummeting prices and the lingering death of insolvent banks. There was, however, one product everyone wanted: a safe. If you couldn't trust banks to hold your savings intact, why not do it yourself?

No one remembers this history better than Federal Reserve chairman Ben Bernanke, which is why the Fed's Dec. 16 decision to slash a key interest rate to 0.25 percent caused a flicker of fear among those in the know. That measure means that the United States' central bank is gearing up for a full-fledged pre-emptive strike against deflation, the sort of prolonged drop in prices that bedeviled the Japanese until just a few years ago and crippled the global economy back in the 1930s. Some optimists say it's too early to worry. Deflation, they insist, has to be chronic before it can be considered a serious problem; a couple of dips in the inflation rate don't qualify. So even though the consumer price index registered a big 1.7 percent drop in November, and even though that was the fourth monthly decline in a row, it's still a bit too early to get worried.

Two days after the cut, though, Federal Reserve Bank of Dallas president Richard Fisher let the cat out of the bag. "We have to do everything we can to lift the economy up and prevent deflation from taking [hold]," he warned. Fed bankers understand that the threat is not to be taken lightly. Once a deflationary dynamic takes hold, the central banker's traditional tool of reducing interest rates loses its power. You can't drop nominal interest rates below zero, as the Bank of Japan found out to its frustration in the early years of this century. The value of assets continued to erode as prices plunged—a "slow, corrosive force," as Richard Jerram of Macquarie Securities in Tokyo puts it.

And if the central bank isn't prepared to flood the system with lots of new money (as the Fed now seems prepared to do), a downward spiral can set in. No one wants to lend, since the loans will be worth less by the time creditors get around to paying them back; no one wants to invest in making stuff, since the products may be worth even less by the time they come to market. The scenarios look even more threatening for an economy ridden with debt, as America's is right now. In a deflationary environment, debts mushroom over time. But because the products and services produced by the debtor are losing their value, paying off the debt gets harder and harder.

Could it happen in the United States today? The Fed has now demonstrated that it doesn't intend to wait and see. That means there's still hope the United States could avoid its own Lost Decade.