Could Fed's Move Against Deflation End Up Backfiring?

If you weren't worried about deflation, you may be now—thanks to the Federal Reserve's latest move to jumpstart the languid economy.

In fact, some economists think the central bank's implicit concern about falling prices could help bring about the very situation the Fed is trying to avoid.


"This gets to be a gamesmanship situation," says economist A. Gary Schilling. "On the surface, the Fed is reacting to the threat of deflation and a weak economy. Does it have deflationary implications? I think it does because it says the Fed is concerned. They're obviously preparing more and more for it. People say, 'Maybe I ought to prepare for it?'"

With both Wall Street and Washington looking to the central bank to do something else to revive what many see as a flagging growth, the Fed's monetary policy committee Tuesday said it would "help support the economic recovery in the context of price stability" by buying longer-term Treasury securities, while downplaying inflation.

"The Fed didn't use the D word in its statement but that's certainly implicit in its thinking," says Scott Anderson, senior economist at Wells Fargo.

After the statement's release, stock prices cut losses and more importantly Treasury prices rallied further. But investors woke up Wednesday and essentially asked, "What just happened?"

In a double-take Wednesday morning, almost every asset class, from gold to oil to stocks, fell ... except Treasurys—the prime beneficiary of the Fed's move—whose monster is inflation.

Few economists see actual deflation in the wings. But given the the economy's slow growth, marked by weak demand, and a spate of recent reports showing falling prices for goods and services, they say deflationary expectations are real and growing.

Economists admit that though the price of many durable goods has been falling, if you take food, housing and oil out of the consumer price index, prices are decidedly higher. What's more, wages—a key ingredient in the deflationary equation—are not falling.

"It isn't deflation per se that bothers the Fed, it's deflationary expectations," explains Schilling.

Economists say Fed boss Ben Bernanke and the FOMC memmbers may have wanted to seem assertive and reassuring in its policy initiative, but at this point the move appears to have backfired.

"It's almost as if their statement now is contributing to deflationary expectations," says Chris Rupkey, chief economist at Bank of Tokyo-Mitsubishi, who otherwise does not subscribe to the deflation argument.

Economists and money managers say the Fed clearly intends to push intermediate and long term rates lower, much as it has with short term rates, to encourage demand and risk, whether it's lending and borrowing or production and consumption, all of which supports price appreciation, not depreciation.

"They're hoping it creates a positive economic impact to avoid that [deflation]," says Jim Awad, managing director at Zephyr Management.

Much like with the recent rally in Treasurys, analysts and investors are rightly asking just how low the Fed can go.

A relentless push has its hazards. One is a perpetual flight to quality and the safe haven of Treasurys.

Schilling, for instance, says he's still buying 30-year bonds, now yielding about four percent and headed to three percent. That's probably a safer bet than stocks yielding a big return anytime soon, he says.

"It's OK if they can jawbone long-term rates lower," says Rupkey. "It's not the Fed pushing rates lower today. It's the Dow falling 200 points that brings rates down. If it's also hurting the stock market, the impact of wealth loss is going to overwhelm the lower prices and potential consumption."

Another risk is that cheaper and cheaper money becomes another reason for consumers and businesses to wait to do anything, defying the normal inflationary cause and effect.  

"They're pumping up money as much as they can, which is supposed to be inflationary," says Ken Goldstein  of the Conference Board. "But in the short term you do have kind of a deflationary pressure to it. It's about timing."

Meaning , if the strategy works, it reinflates the economy, before deflation sinks it.