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Think the Fiscal Cliff Was Bad? This One’s Worse

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Almost a year after policymakers and the public were consumed by worries over the fiscal cliff, a distinguished economist is warning that the U.S. and the world are nearing a far more precipitous plunge over the monetary cliff.

John Makin, a resident scholar at the free-enterprise-oriented American Enterprise Institute (AEI), says the Fed’s fixation on fears of inflation — including its tinkering over tapering, reflects the risk that policymakers are blind to a dangerous sneak attack by deflationary forces.

Writing in AEI’s November Economic Outlook, Makin suggests that the announcement and later retreat from tapering “represented a policy failure, both of the Fed’s forecasting ability and of the Fed’s ability to clearly communicate its policy intentions to markets.”

The monetary policy expert goes so far as to suggest the Fed consider signaling an increase in quantitative easing (QE), as a means of preventing a self-reinforcing deflationary spiral that risks driving down investment, spending, lending and employment.

The danger deflation poses is evident in the current disinflationary trend, whereby inflation rates in the U.S., Europe and China are in decline. Once inflation goes from low to negative, experience shows the difficulty of reversal. For example, the Japanese economy has lagged under deflation for 15 years, and the aggressive reflationary measures undertaken over the past year of “Abenomics” has merely pushed Japanese core inflation to 0%—too early to declare victory over deflation.

While the popular consumer price index measure of inflation fell after the Lehman crisis into deflationary territory in 2009, then recovered to positive levels in 2011, the world’s major economies have been disinflating now for two years.

While the U.S. rate now hovers below 2%, Makin worries that the core rate, which strips out volatile food and fuel prices, is moving perilously close to zero, and from there to deflation. Core inflation in the U.S. is about 1.5%; in Europe it is about 1%.

Unlike the fiscal cliff, which had a set date and could be averted by policymakers, a monetary cliff has no set date but is rather “data dependent,” Makin warns. Once we cross those data thresholds, deflation produces four ill effects.

First is an increase in real interest rates, which discourages investment and other spending.

Second is a rise in the demand for cash and concomitant decline in demand for goods.

“As resulting deflation expectations become embedded in the minds of households, the central bank faces the formidable task of reversing such expectations,” Makin writes. “Left alone, a drop in deflation leads only to further deflation.”

The third effect of falling prices is a rise in the cost of repaying debt, leading to increased default, damaged lender portfolios and diminished willingness to lend.

Fourth, the fall in prices pushes up real wages, which reduces demand for labor. In the current weak economic recovery, real wage growth has been steadily heading toward zero since mid-2011 and employment growth has been tepid. If deflation were to occur, employment growth would be weaker still.

The remedy for deflation and for disinflation, Makin argues, is “antithetical to the thinking of many central bankers.” It requires promising inflation and then actually achieving inflation at the level promised. The Bank of Japan has made noise about targeting inflation since 2008, but has not gotten there, and fiscal policies that undercut inflation, such as a promised hike in its consumption tax, only encourage doubt about its prospects for success.

Also complicating matters is global economic interdependence. Weakening a currency can help fight deflation, but every country cannot reduce the value of their currencies at the same time. U.S. QE, by weakening the value of the dollar, has tended to export deflation to the rest of the world, causing slower growth, for example, in China and making Chinese policymakers “especially unhappy.”

Makin recommends three policy directions for the Fed to fight the threat of deflation. First, the Fed should “restate the desirability of boosting inflation.”

Second, the Fed should set a hard lower bound for inflation. Makin suggests specifying an inflation target of 0.5% to 1.5%. “With that target range, a drift of inflation below the 1% level would lead to increasing emphasis by the Fed of its commitment to avoid deflation,” he writes.

Third, Makin suggests that Bernanke’s presumed successor Janet Yellen “should resist the temptation to sound hawkish in view of her, probably unwarranted, reputation as a dove on inflation.” Rather, she could reduce the risks attendant upon deflation fears by openly discussing these risks and stating the Fed’s unwillingness to tolerate it.

Check out 3 Reasons Why You Need Inflation Protection Now on ThinkAdvisor.