US at the risk of deflation

AGENCIES Nov 5, 2008, 04.50am IST

When policymakers at the Federal Reserve voted to slash interest rates at their October 28-29 meeting, it's a good bet the threat of deflation played a role in the decision. That concern is bound to get more attention in coming months as inflation begins to fall amid a progressively weaker economy and the financial crisis.

Deflation is an economic disease caused by a sustained drop in overall demand and falling prices that forces businesses to cut prices ever deeper. It was last seen in the US in the 1930s and in Japan in the 1990s, when the inflation rate fell to zero and then turned negative for several years.


For new loans, it raises the real, or inflation-adjusted, cost of credit, the opposite of what monetary policy needs to do to combat falling demand. The risk of deflation is small but not at all trivial. The last threat in the US followed the tech bust and recession in the early 2000s.

Back then, the Fed fought off by cutting its target rate to 1% and keeping it there for a year. But the power of those rate cuts was aided by a strong financial sector. Without that backstop this time, the US faces a new round of deflationary forces.

All of the factors that fuelled earlier inflation worries have sharply reversed course: Consumers are retrenching. Job and wage growth are weakening at faster rates. The stronger dollar is pushing down import prices.




Those declines are part of a broad deleveraging by financial firms and households. This forced casting off of debt is fuelling the sale of homes, stocks, and other securities at fire-sale prices while shutting off new lending in a self-reinforcing spiral that destroys wealth and depresses demand. The virulence of this deleveraging process makes this business cycle even more susceptible to deflation.

The Fed's efforts to keep deflation at bay are already massive. Through Oct. 22 it has lent some $700 billion to bank and non-bank institutions. That's apart from the Treasury's $250 billion injection of capital into banks and its planned purchases of illiquid mortgage-related securities.

Plus, rate cuts, totalling 4.25 percentage points since September 2007 and including the half-point reduction on October 29, have taken the target rate down to the same 1% it hit earlier in the decade.

Paper money

The total outstanding commercial papers (CP) increased substantially from Rs 32,592 crore at end-March 2008 to Rs 54,182 crore at mid-September 2008 in line with the seasonal pattern observed in case of CP issuances.

Though leasing and finance companies continued to be the major CP issuers, the share of manufacturing companies is growing. This is largely because other avenues like the overseas funds and domestic capital market have dried up.

Debt worries

INDIA'S external debt has touched $220 billion. This is a comfortable level, given that the stock of foreign currency reserves is still way above $250 billion even after a massive reduction over the past few weeks on account of FII sellout.

However, the high proportion of short-term debt in the total debt is a cause for concern. This could add to further volatility in the capital flows and currency markets.