MNI EXCLUSIVE: Deflation Nightmare Seen by Ex-Fed Economists

By Pedro Nicolaci da Costa

     WASHINGTON (MNI) - Deflation poses a nightmare scenario to the U.S. economy

through a prolonged hit to consumer demand combined with a stronger dollar,

former top Fed economists told MNI.

     The coronavirus crisis and its global impact have thrust the world's

largest economy into a deep recession that could last well into next year,

former Fed staffers told MNI. U.S. unemployment has probably already surged into

double digits, though official numbers aren't released until May 8.

     "This could be the thing that tips us into a Japan-style deflation," Seamus

Brown, a senior strategist at Moore Capital who worked at the New York Fed

during the financial crisis, told MNI in an interview.

     That threat is made worse by the prospect that "the Covid outbreak in

emerging markets causes a dollar squeeze externally that causes significant

dollar appreciation," he added. 

     Combined with knock-on effects from housing market deterioration, including

cascading mortgages defaults and missed rent payments, and "you can imagine core

goods prices having substantial deflation," he said, referring to the range of

raw materials that go into construction.

     --'REAL POSSIBILITY'

     The Great Depression was the last time that Americans lived with falling

prices and 30% unemployment. "Tragically, we could see that happen again in the

coming months," Claudia Sahm, a Fed board staff economist for 12 years, told

MNI.

     "Deflation -- a prolonged decline in prices, including outside of food and

energy -- is a real possibility as a result of the very severe recession," said

Sahm, now director of macroeconomic policy at the Washington Center for

Equitable Growth. 

     Deflation presents a particular challenge for central banks. It's much

easier to rein in a rapidly growing economy that's starting to produce unwanted

price spikes than to stimulate it out of a deep slump -- especially when

official borrowing costs have again been slashed to zero.

     But Sahm is hopeful a "markedly better policy response" compared to the

1930s will make this slump more shallow and less prolonged. Not only has the Fed

moved quickly to stem the downturn, Congress also launched a USD2 trillion

fiscal stimulus, with more spending likely on the way.

     The Fed is meeting this week to set monetary policy and, while no

additional action is expected following its string of recent actions, the

central bank could strengthen its commitment to doing all it can to ameliorate

the crisis.

     --MORE SEVERE

     The Fed hasn't achieved its stated 2% inflation objective on "a sustained

basis since the Great Recession," and now that the coronavirus crisis is here,

"they will fall way short this year and likely for years to come," Sahm said. 

     The headline PCE price index, the Fed's preferred measure of consumer

prices, is expected to fall 0.3% in April from March, while the core PCE index

is expected to rise 0.1%, according to the Cleveland Fed's inflation nowcast. 

     Asked about deflation risk earlier this month, Fed Vice Chair Richard

Clarida told Bloomberg TV the coronavirus shock "is dis-inflationary," adding:

"I don't believe it's deflationary. I think we have the tools to keep the

economy out of deflation and to support the economy through this challenging

period."

     The Fed's past success, however, is no guarantee of future results. This

downturn is already more severe in many ways than the Great Recession of

2007-2009, and it is driven by a health pandemic with no clear end in sight.

     "You would think the collapse in oil prices [might] freak the Fed out"

about deflation risks, Brown said. "You guys haven't delivered on your inflation

target for 20 years at this point, you're having this epic shock."

     During the financial crisis, the Fed faced falling inflation expectations

and some amount of disinflation, but not outright deflation as it launched a

series of then-novel large-scale asset purchases, which Brown contributed to

developing and implementing on the New York Fed's powerful Markets Desk.

     The consumer price index slipped 0.4% in 2009. It could have been a lot

worse, considering the extent of the economic downturn and a jobless rate that

surged as high as 10% in October 2009.

--MNI Washington Bureau; +1 202 371 2121; email: pedro.dacosta.ext@marketnews.com

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