The Rising Threat of Deflation

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Michael Conroy / AP

Gas prices below $2.00/gal. are posted at a Marathon station in Brownsburg, Ind.

Of all the financial challenges the next Administration may face, perhaps the most dangerous — and least appreciated — is deflation. The stunning decline in the price of oil gets the business headlines — and has a good-news feel as it helps cash-strapped American consumers the most — but the cost of an entire range of commodities has also plunged in the past quarter: copper, gold, nickel and steel have all fallen as global demand has weakened. One popular gauge of commodity prices, the Reuters CRB Index, tumbled 22.3% in October, the biggest drop in the index's 48-year history. (See pictures of the global financial crisis.)

With the economy in the U.S. "contracting significantly" in the fourth quarter, as San Francisco Fed president Janet Yellen recently put it, an issue that was practically unthinkable three months ago is now, for the Fed, front and center: the possibility of the U.S. entering a phase of deflation, or protracted declines in the general price level. In its statement accompanying the most recent interest-rate cut, the Fed said, "In light of the declines in the prices of energy and other commodities and weaker prospects for economic activity, [the Fed] expects inflation to moderate."

That's the optimistic view — and, for now, the dominant view of the Fed, most economists believe. But lurking not far from the surface of economic policymakers' deliberations these days is the dreaded d word: deflation. "Sure, we're very cognizant of it," one source familiar with Fed's thinking on the matter told TIME this week. "We don't think we're there yet, but we're very aware of the possibility." So is Wall Street. At Merrill Lynch, chief investment strategist Richard Bernstein issued a report within hours of Barack Obama's election, listing three developments for investors to monitor closely: fiscal stimulus, taxes and deflation. (See pictures of TIME's Wall Street covers.)

Much of today's deflation anxiety results from keen awareness of the Japanese experience of the 1990s. Indeed, New York Federal Reserve governor and vice chairman of the Federal Open Market Committee Timothy Geithner was Treasury attaché in the Tokyo embassy for the first half of that decade. That's when a widespread banking crisis led to a credit crunch, an economic slump and eventually interest rates that were lowered to zero by the Bank of Japan. Even so, Japan's banks, which were in the process of repairing their balance sheets, were extremely reluctant to lend. Thus, even though interest rates were low, the economy weakened. Prices for pretty much everything declined, following a bust in the real-estate and stock markets in Japan. The country entered a decade of stagnation. (See pictures of the Top 10 scared traders.)

Some economists — for now a minority, to be sure — believe the U.S. is at serious risk of a deflationary spiral, even if just a quarter ago, inflation was above the Fed's comfort zone of 2% to 3%. "Compared to Japan's problem a decade ago, this crisis is unfolding much faster and spreading wider due to financial globalization," says Shanghai-based independent economist Andy Xie. A financial system unable or unwilling to lend, a tapped out U.S. consumer, and business now retrenching — and laying people off — all are a formula for possible deflation. What's so wrong with declining prices? For one thing, it makes the real cost of paying off debt that much higher — and for American consumers in hock to the tune of $14 trillion, anything that makes that debt burden more onerous is anything but helpful. (Read "10 Things to Do With Your Money Right Now.")

The good news is that in the U.S. now, as Richard Berner, chief U.S. economist for Morgan Stanley, writes, "The ultimate bastion of defense against deflation is a Fed committed to avoid it at all costs." And that's what we have. Study of the Japanese experience became something of a cottage industry for Fed researchers over the past eight years, and the Fed has responded accordingly: lending directly to banks, backstopping the commercial-paper market (which companies use to raise short-term money), trying to bring yields on both long- and short-term maturities down. Further, Fed chairman Ben Bernanke went out of his way recently not to object to the possibility of further fiscal stimulus from Congress. In other words, the Fed is throwing everything but the kitchen sink at avoiding a deflationary spiral, and it's doing so more quickly than its counterparts in Tokyo did a decade ago. Disinflation — diminishing inflationary pressure across the board — is healthy for the U.S. economy. Deflation is something the U.S. doesn't want to see. And the Fed knows that better than anyone.

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