Fighting deflation with inflation

For years, the Federal Reserve has been fighting the “silent killer” known as inflation, but the emergence of an even more destructive economic threat, deflation, has made its former adversary a preferred foe.

The threat of a spiral down in prices, wages and economic activity inspired an unprecedented response last week from the Fed, which pushed interest rates near zero.

It’s easy to see why the central bank has gone nuclear, considering the poor record of fighting deflation. Highlights — or, low points — include the Great Depression of the 1930s and Japan’s lost decade of the 1990s.

Many economists give Fed chief Ben Bernanke, a student of deflation and the Depression, high marks for aggressive action to prevent just such a problem.

They figure Bernanke ultimately would prefer a struggle against inflation rather than a debilitating slide into deflation. In fact, it may be just what he has engineered for the central bank further down the line.

“They can always control inflation in the future, but deflation can be very destructive,” said William Larkin, fixed income portfolio manager at Cabot Money Management in Salem, Massachusetts.

“They always say inflation is the silent killer … a lot of people are not aware that they are being robbed. Deflation is basically, you don’t have a job — you have no money. It’s right in front of you and it’s harsh reality.”

The U.S. deflation chronicles expand during this holiday-shortened week with the publication of key gauges of prices, both real and expected.

Japan is on the same theme with consumer prices, as well as unemployment, industrial output and retail sales.

The euro zone offers national data on consumers, including German consumer sentiment, French consumer spending and Italian consumer confidence.

The U.S. housing market, whose two-year implosion caused the current economic crisis, will figure prominently in data on Tuesday. So too will the final reading on third-quarter gross domestic product, which includes price readings.

MOST WORRYING

Officials fear deflation because it brings a severe loss of confidence, which creates expectations that prices of goods, services and a range assets of will grow cheaper by the day.

Normally, consumers welcome falling prices and businesses are cheered by lower costs. But the self-reinforcing nature of the deflation spiral causes spending throughout the economy to halt. In the case of the Great Depression, that led to widespread unemployment and bankruptcies.

For policy-makers, inflation expectations are a key element in heading off deflation before it starts.

Tuesday’s inflation expectations gauge in the final Reuters/University of Michigan consumer sentiment report for December will be studied closely.

The preliminary report earlier this month showed one-year inflation expectations fell to their lowest in five years.

It also showed 22 percent of consumers expected deflation during the year ahead, the highest proportion to anticipate declining prices in the past half century.

Falling home prices have been a prominent deflationary influence, dropping more than 20 percent since the air began rushing out of the housing bubble in 2006.

This has been a key focus of the Fed, which last week reaffirmed its commitment to buy mortgage securities to put a floor under house prices and revive home lending.

“Right now I think the jury is out on whether or not you are going to see some kind of stabilization in the real estate market,” said Thomas di Galoma, head of U.S. Treasury trading at Jefferies & Co. in New York. “I think until you see the stabilization there, it is going to be very tough for the Fed to fight the deflationary spiral that we seem to be in.”

CRISIS OVER, CRISIS BEGINS

Still, the Fed’s efforts have been considerable, and may have already sown the seeds of recovery. If this is true — a big if — it also means inflation, although not immediately.

Liabilities on the Federal Reserve’s balance sheet, stemming from its sundry rescue efforts for the financial system, rose to a record $2.295 trillion in the latest week, Federal Reserve data showed on Thursday.

Its attempts to resuscitate the credit markets have born fruit. Since the Fed’s rate decision last week, the premium that highly rated corporations pay to borrow money dropped to its lowest in about a month compared with government bonds.

Risky companies benefited even more, with rates on high-yield bonds posting their biggest three-day drop on record relative to U.S. Treasuries, a key borrowing measure.

While the Fed has cranked up the printing press and cut interest rates to the bone, economists also expect a massive fiscal stimulus package, possibly as much as $1 trillion, from the incoming administration of President-elect Barack Obama.

All of this spells inflation, even if not in the coming year, according to Roland Manarin, president of Manarin Investment Counsel, Ltd., in Omaha, Nebraska.

“Forget about deflation,” Manarin said. “Long term, we are facing steep inflation.”