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

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.