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Fed eyes moves against deflation

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

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Declining energy prices help the economy by easing what had been a rising burden on consumers. In that sense, the recent price drop is not a bad thing.

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The risk is if a deflationary psychology takes root. Consumers and business would defer decisions, which could deepen the recession and push prices down further. How does a distressed homeowner sell, when buyers are waiting for prices to fall further? Why would a "vulture" investor offer to buy a distressed bank's high-risk mortgages, if they're expecting still lower prices in the future?

In a financial crisis, deflation hits debtors especially hard. The burden of their debts is rising relative to a decline in the overall consumer price level.

Some economists say a little inflation would help turn the psychology that's part of the current crisis. "If inflation rises, nominal house prices don't need to fall as much [for the market to stabilize]," Harvard University economist Kenneth Rogoff wrote recently in Toronto's Globe and Mail newspaper.

So, what can the Fed do?

It has already cut its short-term interest rate effectively to zero. It has also moved to supply liquidity to financial markets – buying everything from mortgage-related securities to short-term debt issued by industrial firms.

The result is to help stabilize the financial system, but buying assets has also had the effect of adding to the money supply.

While the Fed hasn't emphasized this point, these policies amount to what economists call "quantitative easing" of monetary policy. By boosting the quantity of money, it fuels potential future inflation.

One idea, some economists say, is to keep expanding the money supply. Another might be for the Fed and Treasury to signal that they expect inflation to pick up once again, such as by investing in the Treasury's inflation-protected bonds.

In its meeting this Tuesday and Wednesday, Fed-watchers generally expect little new action, as the Fed waits for President Obama's economic team to define its approach the banking crisis.

"If you start to break the deflationary cycle, then people will shift out of cash," says Brian Bethune, an economist at IHS Global Insight in Lexington, Mass. "Then people will start to think about buying stocks and buying houses."