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Fed eyes moves against deflation

With consumer prices expected to fall further, economic recovery might be tougher to achieve.

By Staff writer of The Christian Science Monitor / January 28, 2009

Falling prices: Lauren Goodwin shops at a closing sale at a store in Hoboken, N.J. Retailers have been offering big markdowns in the past few months.

Ann Hermes/the Christian science Monitor

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Despite the Federal Reserve's historic moves to ease monetary policy, forecasters expect consumer prices to post a rare decline this year – a potential threat to economic recovery.

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The challenge: Reviving the confidence of businesses and consumers tends to be much harder when prices are falling.

In a deflationary climate, the predisposition is to postpone economic activity, because things are expected to become even cheaper.

That basic psychology, as well as the obvious distress in America's banking system, is something Fed policymakers have been weighing in recent meetings.

"[Fed chairman] Ben Bernanke is rightly concerned about deflation right now," says Desmond Lachman, a financial expert at the American Enterprise Institute in Washington. "Getting inflation back into the system … is not going to be sufficient," but it would help to resolve the financial crisis.

This idea can seem counterintuitive. The Fed's typical worry is about keeping inflation from running out of control. And it was the runaway rise in US home prices that helped set the stage for the current crisis.

Economists aren't of one mind on the right course for central bankers now. Some are concerned that efforts to revive growth could sow the seeds of an inflation problem down the road.

Yet in rare times, deflation can become a much bigger problem than inflation.

Recent indicators suggest at least a risk that this may be one of those times:

•On Tuesday, consumer confidence fell to a historic low, as measured by the Conference Board in a survey going back to 1967. The confidence of chief executives to make new business investments has also plunged in recent months.

Standard & Poor's reported another monthly decline in its Case-Shiller home price index. A 20-city national average is down 25 percent from the home price peak reached in 2006.

•The consumer price index shifted down sharply as the recession deepened last fall. The bulk of this relates to a reversal in oil prices, but markdowns by holiday retailers were a sign of the new times.

A tally of about 50 forecasters by Blue Chip Economic Indicators finds the consensus expectation for consumer prices this year is deflation of 0.4 percent.