With fresh signs that the housing market is weakening, the Federal Reserve chairman, Ben S. Bernanke, on Friday will offer his outlook on the economy, explain the Fed’s recent modest move to halt the slide and possibly outline other actions.
Mr. Bernanke’s speech, at an annual Fed symposium in Jackson Hole, Wyo., will be his first public comments since the Fed announced it would invest proceeds from its holdings of mortgage bonds to buy more long-term Treasury securities to prop up the recovery.
It is not known what Mr. Bernanke will say, but some insight may come from an episode in his past: his concern, soon after he became a Fed governor, that the economy was at risk of deflation as the nation gradually recovered from the dot-com bust a decade ago.
Mr. Bernanke’s worry then is similar to what troubles the Fed now, and his views will have no small bearing on the Fed’s course of action. These days the Fed confronts the combination of persistently high unemployment and an inflation rate so low that it worries economists.
Whether policy makers should take big steps to tackle the economic doldrums — by printing even more money and buying even more assets — will be the dominant question at the symposium and at the Fed’s next meeting on Sept. 21.
Within the central bank, several officials are alarmed at the threat of the economy falling into a dangerous cycle of declining demand, wages and prices not experienced since the Depression. They say that a deflationary, double-dip recession is unlikely, but want to formulate concrete steps to ward it off.
Other officials contend the economic indicators, while dismaying, do not represent an immediate threat, and worry that additional monetary stimulus by the Fed could erode the already shaky confidence of the markets, or even backfire by eventually spurring uncontrolled inflation.
The Fed has not confronted the risk of deflation since 2003. An examination of transcripts from the deliberations of the Fed’s policy-making group, the Federal Open Market Committee, during that spring sheds some light on the challenges Mr. Bernanke faces in maintaining a consensus in the committee as it approaches the problem today.
In a confidential briefing before the committee’s meeting on May 6, 2003, Fed economists estimated that there was a 35 percent chance that the fragile economy, still recovering from the 2001 recession, would face deflation by the end of 2004.
Mr. Bernanke, who had joined the Fed’s board of governors just nine months earlier, warned about the potential danger of deflation, according to the 2003 transcripts, which were made public last year. He said that “for the first time in many decades” the Fed faced greater danger from the risk of its inflation estimates being too high, rather than too low.
He wanted the Fed to draft “a plan for how we might proceed seamlessly from standard rate-cutting to more nonstandard operations should such operations become necessary.”
It would be five more years — and one boom-and-bust cycle later — before the Fed would have to apply that advice.
The Greenspan view ...
In the meantime, Mr. Bernanke’s perspective appeared to influence that of Alan Greenspan, then the Fed chairman.
“In my view we cannot avoid the fact, as Governor Bernanke pointed out, that we face an asymmetry,” Mr. Greenspan said at the May 2003 meeting. “We know what to do with inflation when it rises. The committee has taken action to counter it many times and has succeeded in doing so many times. We haven’t confronted the problem of potential deflation in a very long time.”
That view was echoed by several other committee members, even among those who pointed out that disinflation, a slowing of the rate of inflation, was not the same as deflation.
Robert T. Parry, then president of the San Francisco Fed, said, “It’s best to move sooner rather than later when the economy is within range of deflation and the zero bound.” He was referring to the challenge the Fed would face if it had to reduce short-term rates to nearly zero and could no longer cut them any further — a situation the Fed has faced since 2008.
Others were skeptical. George C. Guynn, then president of the Atlanta Fed, said the situation was not comparable to the Depression. “We clearly have experienced significant external shocks,” he said. “But the real economy is recovering, albeit slowly. It is not contracting.”
To prop up the economy after the dot-com boom’s collapse, the Fed lowered its benchmark short-term rate — the federal funds rate, at which banks lend to each other overnight — to 1.25 percent in November 2002, from 6.5 percent in January 2001.
On June 25, 2003, it reduced the rate even further, to 1 percent, the lowest level in decades. In the meeting where that decision was reached, Mr. Bernanke wondered “whether or not it would make sense tactically to say publicly that we are willing to lower the federal funds rate to zero if necessary.” He said it would help expectations because “there would no longer be a feeling in the market that we had reached the end of our rope.”
The threat of deflation did not come to pass, and a year later, the Fed began to raise interest rates and tighten monetary policy, a process that would continue until 2006 as housing prices soared across most of the country. Some critics have said the Greenspan Fed helped abet the housing bubble by leaving rates too low for too long, an interpretation Mr. Bernanke has rejected.
Mark W. Olson, who was a Fed governor from 2001 to 2006, said the Fed’s worry about deflation in 2003 was appropriate in hindsight. The committee had only two historical episodes to look to — the Depression of the 1930s and the Japanese deflation that began in the 1990s — and was determined to avoid either outcome, he said.
“It would have been irresponsible for us not to take it into consideration,” Mr. Olson said. “It wasn’t much ado about nothing.”
Of the Fed committee members who weighed the threat of inflation in 2003, four are still on the committee today: Mr. Bernanke; Donald L. Kohn, a Fed governor; Thomas M. Hoenig of the Kansas City Fed; and Sandra Pianalto of the Cleveland Fed. There is little doubt that the Fed’s last deflation debate has been on their minds as they confront an even more perilous economic outlook today.