Yesterday, for the second time in a month, Federal Reserve Chairman Alan Greenspan called deflation a sufficiently large threat to "require very close scrutiny and maybe . . . action on the part of the central bank." Earlier this month, the Treasury suggested that while the U.S. would like to see a strong economy and strong currency, "the dollar's value is best set in an open, competitive currency market with minimal intervention."

The announcements created an inordinate stir. The Fed's acknowledgment of the incipient deflationary pressures marks a 180-degree turn from the battle against inflation initiated by Paul Volcker in October 1979. But it was about time: The global economy continues to suffer from a lack of adequate demand growth and the attending concern of global deflation.

The Treasury's return to benign neglect of the dollar is more revolutionary in practice than in principle. The period of accelerating global inflation during the 1970s was the last time it happened. Back then, the weakness of the dollar was of particular concern because it was deteriorating faster as a store of value than the harder European currencies like the Deutsche mark and the Swiss franc.

The recently initiated dollar weakening, on the other hand, holds potentially good news for the world economy. In a world of deflation, measures to weaken a country's currency help to offset contraction while stemming the speed of deflation. Most policy makers today were raised in an inflationary environment and have been trained to think that a stronger currency is always better, but this isn't the case. Sustainable recovery in the U.S. needs the buttressing of reflationary measures. The important thing now is for Europe and Japan to follow suit.

This is not a time for complacency. The Fed elected to target higher growth and inflation in a U.S. environment reminiscent of Japan in the mid-1990s. Inflation, broadly measured in the U.S. by the core personal consumption deflator, is falling rapidly despite over 500 basis points of Fed interest-rate cuts. The latest inflation numbers showed an annualized inflation rate of 0.9 percent for the three months ending in March, down sharply from a 1.5 percent year-over-year rate. In effect, a measured inflation rate below 1 percent suggests zero inflation.

When inflation keeps drifting downward while growth weakens, as has happened since last fall, profit expectations deteriorate. Weaker profit growth pushes investors into cash and low-risk alternatives like 10-year Treasury notes, reinforcing the deflationary trend. A bounce in profits growth did occur during the first quarter of 2003, resulting in a modest uptick in equity prices. But the outlook for earnings growth and profits looks weaker as hopes for a second-half recovery in investment spending begin to fade.

Mr. Greenspan and other members of the Federal Reserve Open Market Committee have, since February, emphasized the hope that the U.S. would recover rapidly after the war and that a sustainable recovery would be led by an investment rebound in the second half of this year. It hasn't happened. In recent weeks, the signals on the investment rebound started to turn negative. The preliminary report on first-quarter GDP showed that the brief rebound in business fixed investment to a positive 2.3 percent annual rate at the end of last year actually relapsed to a negative 4.2 percent annual rate in the first quarter of 2003.

A more current survey of investment spending plans conducted by Goldman Sachs showed that plans for spending on information technology, a key sector, deteriorated sharply between February and April of this year. In February, 23 percent of survey respondents indicated that they expected to see an acceleration in their IT spending in the second half of 2003. By April, only 4 percent expected to see an acceleration in IT spending by the second half of 2003.

The economy is beginning to suffer from manana syndrome: Once again, hopes for a second-half recovery are fading into hopes for a recovery "next year." But as the Fed has pushed short-term rates closer and closer to zero, its ability to keep recovery hopes from slipping has become more and more limited. A new monetary regime targeting a stable, positive level of inflation instead of interest rates may be just the ticket.

The dollar's move downward probably has further to go. Major currency moves tend to be of long duration. The dollar rose nearly 50 percent from its low in 1995 to its high early in 2002. Since then, the drop has only been by about 10 percent--a drop in the trade-weighted dollar by another 10 percent or 20 percent would not be at all out of the ordinary. Whether the dollar weakens further depends on the response by other countries.

The appropriate response from foreign central banks, as Treasury Secretary John Snow has suggested, is to avoid intervention aimed at preventing the dollar from depreciating and to cut interest rates further to help stimulate demand in their own economies. This is especially true of the European Central Bank, which has been reluctant to ease until its backward-looking measure of inflation gets below 2 percent. A strengthening euro will quickly push the Europe-wide inflation rate well below 2 percent and should usher in another 100 basis points of easing by the ECB by this fall.

A weakening U.S. dollar presents special problems for Japanese policy makers since interest rates there are already at zero. The initial response of the Japanese to the weaker dollar is the wrong one. They have chosen aggressively to increase intervention in currency markets to support the dollar and to resist yen appreciation. A better tactic would be for the Japanese to take the upward pressure on their currency as a sign of the need for more aggressive reflationary measures. Such measures would include setting a target for a positive inflation rate and aggressive purchases of assets by the Bank of Japan directly from markets rather than through its zombie banking system.

With the right responses abroad, these ingredients could cook up a global economic recovery. U.S. tax cuts will also help movement toward that goal, especially by increasing the economy's capacity for growth once demand recovers. In the short run, tax cuts at the federal level will be necessary to offset sharp tax increases at the state and local level.

Just as tax cuts that drive up the budget deficit for a time make sense in a post-bubble economy burdened with excess capacity, so a weaker currency makes sense in a world threatened with growing deflationary pressure. The Bush administration has learned these lessons and turned them into action. Let's hope that Congress and central banks in Europe and Japan will do the same thing. If that happens, the U.S. recovery will go global.

John H. Makin is a resident scholar at the American Enterprise Institute.