For much of the past year, Ben Bernanke has caught a lot of flack for being too soft on inflation. Journalists mocked the Fed’s apparent reliance on core inflation, which ignored the big food and energy price hikes that were of most interest to consumers. Many economists–and a couple of Federal Reserve Bank presidents–worried that the Fed was being too aggressive in lowering interest rates. Foreign central bankers seemed to think Bernanke’s fears of a sharp economic slowdown were overblown.
Helicopter Ben isn’t looking so dumb now, is he? The inflationary pressures from commodity markets have all reversed. The pressure on prices from every quarter–miserly banks, scared consumers, retrenching corporations–is now decidedly downward. Deflation is the specter haunting the world, and the Fed has been leading the way in fighting it. It ‘s likely to take took another step in that direction this afternoon by lowering short-term interest rates yet again, probably to 1%, matching the previous all-time low target maintained from June 2003 through June 2004 (the actual Federal Funds rate dropped below 1% a couple times in the 1950s, back before the Fed announced a target rate).
Deleveraging, which is entirely necessary and which we’re already seeing happen around the world, can combine with deflation to bring some really horrible results. I’ll let Irving Fisher explain, from his 1933 paper on “The Debt-Deflation Theory of Great Depressions”:
(1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.
This is what Bernanke has been worrying about for the past year (and he was worrying about it back in 2002 too). Now that almost everybody seems to be joining him in his concern, maybe we ought to give him a little more credit for having been right.