US Economists Warn The Fed Is Setting Us Up For Deflation

Home prices are stagnant, crude oil is tumbling and copper has fallen to a seven-month low. Inflation is not the problem. What is the problem is inflation's evil twin, deflation.

And as good as today's beginning stages of deflation may feel, especially when filling up at a service station or shopping for a house, economists warn that there is a high price to pay down the road and that current monetary policy is only raising that price.

Of course, not all price reductions are created equal. A price drop that stems primarily from an increase in technological efficiency is not deflation; it's progress. Deflation is a fall in prices that stems from a shrinking money supply, just as inflation is a price hike that stems from an increase in the supply of money.

Deflation ramps up when people borrow to make a big purchase on the assumption that what they are buying will be worth more later. But if prices fall, the loan will have to be repaid in dollars that are worth more than the dollars they borrowed, making the debt more onerous. As a result, when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. And when that happens, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. It's a nasty cycle and it can often be traced back to the central bank's balance sheet expansion.

Deflation is the one thing that a leveraged economy can't handle, said Steve Blitz, chief economist at ITG Investment Research. The implication on the whole economy is potentially ruinous. The idea that every time the stock markets have some kind of a hiccup and they [the Fed policymakers] need to rush in with some sort of quantitative ease is a dangerous road for them to go on.

Money Printing

Deflation is always a risk if you engage in a policy of inflation, said Albert Lu, managing director and chief portfolio manager of WB Advisors.

The problem with the addiction to money-printing is that it can't stop without dire -- albeit in the long-term healthy -- short-term economic consequences, he said.

To jump-start the economy, the central bank would increase the money supply and bank credit to support certain sectors or projects. That's what the Fed did after the dot-com bubble of 1995-2000 burst. The problem is that once the Fed stops the infusion of additional credit and money, deflation rapidly takes hold. It then takes an ever-increasing amount of new money creation to achieve a temporary suppression of deflation's symptoms.

Inflation-sustained projects are unsustainable because the expansion rests on government fiat, not economic fundamentals like supply and demand. Take the government's determination to promote home ownership. That public policy was advanced with easy money, especially during Alan Greenspan's leadership of the Fed, compulsory lending to unqualified borrowers and Fannie Mae and Freddie Mac buying tranches of subprime mortgages. Home ownership boomed. And then it collapsed. Home prices still haven't recovered: U.S. home prices fell in March (the latest data available), ending the first quarter at the lowest levels since the housing crisis began in mid-2006, according to Standard & Poor's Case-Shiller home-price indexes. Prices are down roughly 35 percent from their peak in the second quarter of 2006.

Essentially, as soon as the government stops the expansion, you are going to hit one of these deflationary corrections with all of the nasty business cycles that accompany it, Lu said.

And often how the government reacts to that is with additional stimulus. For a third year in a row, the U.S. is seeing an economic slowdown and in response, policymakers could be unveiling policy sequels such as: Fiscal Stimulus 4, Operation Twist 2 or Quantitative Easing 3.

They are basically keeping the thing going by continuously adding money and credit, Lu said. This is just delaying the correction we need.

We've been prolonging the agony, and the final correction will be much worse than it had to be, Lu said.

Let Them Fail

The depression of 1920-21 shows why the Fed should sit on its collective hands at their June Federal Open Market Committee meeting.

From the spring of 1920 to the summer of 1921, nominal gross domestic product fell by 23.9 percent, wholesale prices by 40.8 percent and the consumer price index dropped by 8.3 percent. Meanwhile, unemployment topped out at about 14 percent from a pre-bust level of as low as 2 percent.

In response, the administration of Warren G. Harding balanced the budget and the Fed tightened money supply, pushing up short-term rates in mid-depression to as high as 8.13 percent.

Harding also decided to let the ailing businesses fail. Then something wonderful happened: The economy purged itself and by 1923, the nation's unemployment rate fell back to 3.2 percent.

There was no government bailout, no rock-bottom interest rates, no QE, no stimulus of any kind. Yet the depression ended.

We actually need a deflation. Believe it or not, it's actually healthy, Lu said. However painful it is, deflation is the natural consequence of prior inflation and is a necessary step in the economic recovery.

Trying to avoid it through additional Fed action will prolong the depression, Lu said.