Fed Has Little Ammo Left to Fight Deflation

Central banks unleashing trillions of dollars of low-cost global liquidity are nice, but nothing warms the market's cockles quite like a rate cut. The Federal Reserve is widely expected to trim its short-term target to 1% Wednesday, the lowest level in five years. Let's hope it's low enough.

The last time short-term interest rates were cropped that close it was because then Fed chairman/Ayn Rand acolyte Alan Greenspan feared deflation and recession more than inflation. (See chart below.) Well, you know the rest. We all binged on cheap credit. The massive deleveraging of all that debt on an epic scale has the world teetering on a financial precipice and a recession -- let's face it -- well underway.

Given the apparent folly of his faith in markets regulating themselves, we'd be surprised if Mr. Greenspan is still so Randy. But this much seems clear: It may well be too late for a fountainhead of liquidity to stave off deflation. As the bearish and thus-far prescient Merrill Lynch economist David Rosenberg wrote Monday: "Without a normal credit cycle, Fed-induced liquidity is akin to running on a treadmill."

Paying less than three bucks a gallon at the gas pump is one of the few financial pleasures afforded by our rapidly souring global economy. But it's also a symptom of macroeconomic disease. As bad as inflation is, deflation is worse. It is pernicious, self-perpetuating and harder to manage with policy actions. After all, short-term rates can't go below zero. At that point the Fed has shot its quiver.

And make no mistake, deflation wreaks havoc. Discounts lead strapped consumers to defer purchases, waiting for an even better deal. Companies then must cut prices still further. That eats into margins and profits, hurts earnings and share prices, and forces cost cutting and layoffs. The unemployed spend less, depressing prices more. It's a vicious cycle.

With inflation currently running at about 5% it's hard to get worked up about falling prices. Even core inflation, which excludes food and energy costs, is still growing apace. David Wyss, chief economist at Standard & Poor's, says deflation is hardly at the top of his list of concerns. "Core [inflation] is still 2.5%, so talking about deflation sounds a bit premature at this point," he says. "There's a lot bigger worries out there than deflation."

But Merrill Lynch's Rosenberg, leader of the deflatists, contends that by this time next year it will be the biggest worry we have. Deflationary forces are already in motion, he says, and look irreversible.

A glance across today's asset landscape certainly bolsters that case. Stocks and homes prices are in freefall. Oil has been more than halved from its summer high, metals have dropped 50% and food is down 30%. Debt itself is deflating, as households knocked $11 billion off their outstanding liabilities in the second quarter, the first time that's happened in 25 years. And accelerating job losses are provoking deflation in the labor market. It's a grim picture, one that the Fed can only hope to contain, not reverse, Rosenberg says.

"Even with their best efforts, Messrs. [Hank] Paulson and [Ben] Bernanke cannot prevent Mother Nature from taking its course," he wrote. "We will need aggressively accommodative monetary and fiscal policy to limit the damage to confidence and spending from the recently started recession and the deflation that is around the corner."

If there's a bright spot in this dark scenario, it makes low-but-safe yields actually look good. Treasurys, certificates of deposit and, gasp, even savings accounts could actually generate positive returns.

It sounds perverse but let's pray that doesn't come to pass. After Wednesday's shot the Fed won't have many arrows left.

Rate Changes Since 2003

Source: Federal Reserve Bank of New York