Where's a good deflation-fighter when you need one? US consumer prices fell in October at the steepest rate since 1938. If that starts a self-reinforcing downward spiral in prices, Barack Obama will need Federal Reserve chief Ben Bernanke more than ever. The former Princeton scholar is an expert on deflation, a pernicious destroyer of wealth.
In a famous speech before he became the nation's central banker, Mr. Bernanke said "sustained deflation can be highly destructive'' and it "should be strongly resisted."
His wise counsel was based on his studies of the Great Depression and of post-bubble Japan in the 1990s, times when consumers and businesses were sucked into a rare mental contagion in which they delayed purchases to see if prices would fall further.
Breaking such a negative pattern, or ending a phenomenon that feeds on itself, can take years. A drop in prices may sound good – who doesn't welcome gasoline at less than $2 a gallon or affordable home prices? But when this anti-inflation becomes rampant, people who are paying off their debt in effect pay more in value over time. Spending dries up. The economy contracts.
Avoiding runaway deflation is why central banks tolerate a low level of inflation – it keeps the bigger beast at bay. For most of this year, the US and many other nations had high inflation, mainly because of rising prices for oil and food. So it was a shock that US consumer prices – excluding food and energy – actually fell in October, the first drop since 1982. A sudden fear of deflation helped knock down the stock market.
The reality is that runaway deflation doesn't yet exist. And the task of preventing it lies with Bernanke, whose term at the central bank runs until 2010. His actions may affect Americans far more than those of Mr. Obama.
What's a Fed chief to do? As the éminence grise behind the recent financial rescue plans, Bernanke is very confident the government has the tools, if not always the will, of an FDR to reverse deflation.
The Fed's first tool is to drop the interest rate used between banks to zero. The rate is now 1 percent and may be dropped in December. The Fed can then "inflate" the economy by manipulating long-term interest rates that loosen credit, effectively "printing dollars." It's a move he describes as equivalent to a "helicopter drop of money." Deflation's foe is the US Mint.
The last time the Fed tried to ward off deflation, in 2002-03 under then-Fed chief Alan Greenspan, it overshot and helped create a credit bubble that then fed a rapid rise in home prices. Mr. Greenspan compounded the problem by not reining in the practice of banks taking on risky mortgages. It was, after all, risky loans that were the root cause of the 1929 market crash.
So while Obama must rely on Bernanke to slay the deflation dragon, the new president must also make sure the Fed doesn't overinflate and create another bubble.
How to do that? The Fed must set an inflation target, say at 2 percent, and stick to it. Congress may not like it. Lawmakers sometimes like loose money to create jobs.
Bernanke will need Obama's help to set that target. In fact, the two men will need each other to keep deflation in its cave. This dragon is a creature that must be slain with care.