Fed, ECB prepare to tackle deflation head-on

SAN FRANCISCO (Reuters) - Officials from the Federal Reserve and the European Central Bank on Sunday vowed to fight the damaging effects of deflation as the global economy suffers a deep and lengthy recession.

The Federal Reserve Building in Washington while the Fed is inside meeting, October 29, 2008. REUTERS/Larry Downing

In just a few months, central bankers’ concerns have flipped from fighting inflation to staving off possible deflation -- a condition in which falling prices cause consumers and businesses to delay purchases, resulting in an even steeper economic downturn.

Both Janet Yellen, president of the San Francisco Federal Reserve Bank, and Lucas Papademos, vice president of the ECB, highlighted the risks of deflation at the annual meeting of the American Economics Association.

“It is increasingly likely that inflation will fall to undesirably low levels,” Yellen said at the meeting in San Francisco.

She said the Fed would likely expand its raft of unconventional monetary policy measures now that its cycle of interest rate cuts has hit rock-bottom.

She also urged an aggressive spending program by the administration of President-elect Barack Obama, as she gave a dismal assessment of the economy. Yellen appeared to discount some current forecasts that U.S. growth would start to recover in the second half of 2009.

“The financial and economic firestorm we face today poses a serious risk of an extended period of stagnation -- a very grim outcome,” she said. “Even with vigorous Fed action to restore credit flows, an extended period of economic weakness is likely.”

“I’m strongly supportive of a substantial fiscal stimulus package,” Yellen said. “If ever, in my professional career, there was a time for active, discretionary fiscal stimulus, it is now.”

The ECB’s Papademos, meanwhile, said that more ECB interest rate cuts may be needed to support the euro zone economy and keep deflation at bay.

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“We will do what is necessary, in terms of the timing and in terms of the size (of interest rate policy action) to ensure that price stability is preserved,” he said.

Unlike the Fed, which in December reached the zero-bound on interest rates and is pushing headlong into a type of “quantitative easing” to support U.S. growth, the ECB still has some arrows left in its rate-cutting quiver.

The ECB has cut its benchmark interest rate by 1.75 percentage points in the past two months, to 2.5 percent. Markets now expect another 50 basis point cut at the bank’s next policy meeting, on Jan 15.


Yellen was the second Fed official this weekend to urge aggressive fiscal measures to complement the central bank’s ongoing monetary policies.

On Saturday, Chicago Fed President Charles Evans said that programs to support growth “must be large in order to be effective and to instill badly needed confidence,” given the severity of the downturn.

Yellen and Evans are both voting members of the Federal Open Market Committee in 2009.

Obama has said that signing a major economic stimulus package will be his first priority when he takes office, with a goal of creating or saving 3 million jobs over two years.

Democratic lawmakers say the plan now under consideration in Congress will cost about $775 billion, but Republicans predict a tab of up to $1 trillion.

Renowned economist Martin Feldstein, former head of the National Bureau of Economic Research, said on an AEA panel that stimulus of some $300 billion to $400 billion in both 2009 and 2010 was warranted. He forecast that the U.S. downturn would probably be judged the worst since the Great Depression, and the United States would be “lucky” to return to growth in 2009.

“Speed of the outlays is an important concern,” Feldstein said. “One that spends quickly and then finishes is ideal.”


Papademos told reporters that the ECB will not let inflation fall “significantly below 2 percent for a protracted period of time,” adding that he did not expect such an outcome based on present analysis.

Cutting interest rates to low levels has long-term implications for price stability, he said. Still, on a panel discussion Papademos said that inflation would weaken sharply in the coming months.

In the United States, Yellen referred to the vicious cycle, whereby weakness in the U.S. economy intensifies distress in the financial sector, and vice versa.

In both speeches on Sunday Yellen’s highlighted a risk that, as inflation expectations fall and benchmark rates are held near zero, “real” interest rates will actually rise, at the worst possible time.

“A decline in inflationary expectations when economic conditions are weak is pernicious ... because any downdrift in inflation expectations leads to an updrift in real interest rates and a tightening of financial conditions,” she said.

Editing by Leslie Adler