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Wednesday, June 04, 2003

The Fed's Deflation Firewall Starts a Fire

There is perhaps less clear economic news coming in at the moment, but what there is seems reasonably serious (see Italian pensions post below). This development following a Greenspan conference call seems to indicate just how nervous everyone is. There is one thing about which I am genuinely confused in the inflation targeters' argument, should a drop in long trem rates be considered a good thing (since it makes borrowing cheaper) or a bad one (since it indicates deflation expectations are setting in)? Meanwhile the Bundesbank President informs us that Germany will not have the 'pernicious' Japan-style deflation, it would be nice if he could provide us with some convincing reasoning as to why not.

The markets drove long-term interest rates sharply lower on Tuesday after Alan Greenspan, chairman of the US Federal Reserve, said the central bank would act decisively to head off the risk of deflation. Speaking by satellite to a conference of central bankers in Berlin, Mr Greenspan said the US economy had stabilised in recent weeks, though it had yet to show clear signs of acceleration. But though he also continued to warn that the risk of a vicious circle of "corrosive deflation" was low, the markets seized his comments about the need to establish a "firebreak" to prevent it taking hold.

Two-year US interest rates fell to a record low of 1.19 per cent, dropping below the current short-term policy interest rate of 1.25 per cent. Expectations of interest rate cuts soon rose sharply, with markets pricing in a chance of more than 80 per cent that the Fed will cut rates by a quarter-point at its next meeting on June 24-25. Mr Greenspan's guarded assessment was underlined by a welcome for the short-term boost from last month's $350bn tax-cut package, due to come into effect next month. "I have to admit that, fortuitously, this particular cut in taxes is happening at the right time, although I doubt very much one could have planned that in advance," he said.

The statement contrasted with remarks Mr Greenspan made earlier in the year, when he said it was not clear that the US economy needed the stimulus from a tax cut. Most economists read Tuesday's statements as a signal that Mr Greenspan, while not committing to a rate cut, was leaving the door open if necessary and cautioning against overoptimism. "He is still on the theme that things are getting better but they will have to get better quickly to validate some of the [economic] projections for the summer," said Robert DiClemente at Citigroup.

Several of the large investment banks have made optimistic forecasts that the US economy could reach 3-4 per cent growth in the third quarter of the year. While more confidence in financial markets suggested "a marked turnround" in the real economy, Mr Greenspan said his best judgment was that such an acceleration had not yet begun. "It is too early to get any real fix on the American economy in the period ahead," he said. At the Berlin conference, Ernst Welteke, the Bundesbank president, also admitted that Germany might suffer a period of falling prices, but not the "pernicious" deflation that had gripped Japan.He said: "We cannot, however, rule out the possibility that Germany might experience mild deflation in the near future."
Source: Financial Times

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