Resident Fellow Desmond Lachman

In 2003, at the time of an earlier US deflation scare, Mr. Bernanke delivered his famous "helicopter" speech. In that speech, he emphasized that in principle the Federal Reserve's printing press gave it plenty of ammunition to fight deflation even once interest rates had been reduced to zero. To graphically illustrate his point, he indicated that, as a last resort, the Federal Reserve could always drop dollars from a helicopter to revive spending in the economy.

In his helicopter speech, Mr. Bernanke correctly identified two basic reasons why at all costs one needed to avoid allowing deflation to take hold. First, he noted that consistently falling prices would make it impossible for the Federal Reserve to reduce the real cost of borrowing once interest rates had been reduced to zero, as is pretty much the case today. Second, he observed that deflation would have the toxic effect of increasing the real burden of household and corporate debt. In today's world, where US private debt has rapidly escalated to 290 percent of GDP, rising real debt burdens could very well result in mass insolvency and falling demand.

With unemployment now rising at an alarming rate and with international oil prices collapsing, the deflation threat is again knocking at our door. Over the last three months, consumer prices have fallen at their fastest rate in the past sixty years. Meanwhile, the various measures of inflation expectations suggest that market participants now expect falling prices. This is most vividly illustrated by the fact that yields on the government's inflation linked bonds (TIPS) suggest that markets are expecting that consumer price inflation, excluding food and energy, will decline by 5 percentage points over the next five years.

By aggressively resorting to the printing press to finance large budget deficits and by indiscriminately lending to the private sector, the Federal Reserve certainly has the ammunition to beat deflation. However, moving in that direction runs the very real risk of compromising the country's longer-term economic growth and employment prospects. It would do so through heightening the risk of a burst in inflation once an economic recovery were to get underway. It would also do so by facilitating the crowding out of future investment, by undermining the efficient functioning of the capital market, and by increasing the risk of a dollar crisis.

Before Mr. Bernanke further resorts to the Federal Reserve's printing press, he might want to consider that the major impediment right now to any economic recovery is not that interest rates on government paper are too high. It is rather that we have very deep problems in the US financial system that are inhibiting banks from lending. Despite the literally hundreds of billions of dollars in liquidity injections by the Federal Reserve, and despite the disbursement of around US$350 billion under the Troubled Asset Relief Program (TARP), the US financial system today is practically as dysfunctional as it has been at any time over the past eighteen months. The banks are not lending, the securitization process has all but dried up, and the interest rate spreads that even the best rated of corporations are paying have widened to highly onerous levels.

One has to hope that amongst the very first priorities of the new US Administration will be a radical rethinking of the TARP program in an effort to restore the US financial system to a semblance of normality. One also has to hope that Mr. Bernanke supplements the historic steps that the Federal Reserve took last month toward quantitative easing by adopting two further measures to leave little doubt that the Fed is serious about combating deflation in a responsible manner. The first, which Mr. Bernanke himself proposed in his helicopter speech, would be for the Federal Reserve to provide the public with a quantitative working definition of price stability as a guide to forecasting the Fed's future behavior. The second measure might be for the Fed to purchase government inflation linked bonds (TIPS) as the clearest of indications that the Fed truly believed that it would succeed in avoiding deflation.

Desmond Lachman is a resident fellow at AEI.