February 02, 2004

Deflation: Now or Later?

A very informative piece in the Economist outlines the US Federal Reserve's dilemma. Low inflation has led to extremely low interest rates and asset prices, especially housing, are moving up. A housing asset price boom could set the US economy on a dangerous path when it bursts, sending us into deflation. But with inflation so low, the cure for an asset boom (raising interest rates) could send us spinning into a deflationary spiral right now.

The Economist ends up suggesting a small interest rate hike. I would have to disagree. If the problem is people overextending their debt then that is the problem that should be addressed. The story of the seven fat years and the seven lean years is instructive. People who refinance now and take their savings in payments in order to increase their equity and get out of debt are the smart players in today's economy.

If you're out of debt, you're mostly out of trouble in a deflationary economy. That message has to go out, it has to go out strong, and it can be done without changing interest rates. Both the Presidency and the Fed Chairmen have very loud bully pulpits. It would be highly preferable for them to use those instruments, to encourage savings and investment and debt reduction instead of cranking up the interest rates when inflation is so low and seems poised to drop further.

Posted by TMLutas at February 2, 2004 01:16 PM