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DeLong Smackdown Watch: John Cassidy and Fears of Deflation in 2002-2003

Hoisted from Comments:

Brad DeLong--Economics Only: John Cassidy Makes His Play for the Stupidest Man Alive Crown: A colleague pointed me to your misleading and intemperate posting about my article in the October issue of Portfolio.

With respect, Paul Krugman has nothing to with this. In June 2002, the Commerce Department announced that its final estimate of GDP growth for the first quarter was 5.6 per cent. To be sure, the GDP figures have since been revised down, but Greenspan was reacting to contemporary data. In addition, the revised figures still show growth of 2.7 percent and 2.4 percent in the first two quarters of 2002. Given the widespread fears of a recession after 9/11, it seems to me, and it seemed to others at the time, that the 2002 recovery was, indeed, an amazingly robust one.

As to how to interpret Greenspan's public comments about the likelihood of a recession, which spooked the markets at the beginning of this year, that is a matter of opinion, and you are as entitled to yours as I am to mine. I would just put to you one question: Can anybody imagine Paul Volcker putting himself in the same situation?

Brad, you are forever berating economic journalists. Some of that is healthy: we all make mistakes. But somebody who sets himself up as a professional arbiter needs to have high standards. In this instance, the quality of your research was unworthy of a wire service rookie, let alone a tenured professor at a prestigious university.

Let me just present one more piece of data, apropos of Cassidy's claim that by the summer of 2002 it was clear to all intelligent observers that the danger that the U.S. would fall into a Japan-style deflation was past. He may say that Paul Krugman's 2002 fears of deflation "have nothing to do with this." Will he say the same thing about John Berry? :-)

June 19, 2003 Thursday: Final Edition: Rate Cut Looking Like a Sure Thing; Economy's Continued Weakness, Possibility of Deflation Worry Fed Officials BYLINE: John M. Berry, Washington Post Staff Writer SECTION: FINANCIAL; Pg. E01 LENGTH: 941 words:

Federal Reserve officials, concerned there is still no sign of the solid pickup in U.S. economic growth needed to foreclose the possibility of deflation, appear certain to cut their target for overnight interest rates next week. There is broad agreement among investors and analysts that a rate cut is coming, but there is disagreement about whether policymakers will lower their 1.25 percent target by a quarter-percentage point or by a half-point. The latter seems to be more likely as a sort of exclamation point to emphasize that the officials believe this will be the final step that, coupled with the income tax cut that will show up in workers' take-home pay next month, will put the economy on a strong, sustainable growth path.

Fed Chairman Alan Greenspan, who gave the first hint that he was contemplating another rate cut in testimony before a congressional committee on May 21, referred then to such a step as "taking out insurance." "We believe that because in the current environment the cost of taking out insurance against deflation is so low, that we can aggressively attack some of the underlying forces, which are essentially weak demand," Greenspan told the committee. Several other Fed officials have expressed similar views in recent weeks. By "cost" Greenspan meant the risk that another rate cut could so stimulate economic activity that it would cause inflation to become significantly worse. But in this instance, such an outcome would almost be welcome.

A rate cut by the central bank next week would be the 13th since January 2001 on the eve of a recession when the rate target was 6.5 percent. The Greenspan-led Fed cut rates aggressively as the economy contracted through that year, and growth resumed in 2002. But to the surprise of economists and policymakers, the recovery has been halting and "jobless" despite huge doses of monetary and fiscal stimulus. The U.S. unemployment rate, which had fallen to 3.9 percent in the fall of 2000, was 6.1 percent last month. Now, again, many forecasters are predicting that economic growth will accelerate. They are saying the pickup will occur in the second half of this year, to a fast, sustainable pace that will begin to add jobs and put much of the nation's idle production capacity back to use. Greenspan and his Fed colleagues don't necessarily think those forecasts are wrong; they just aren't convinced they are right.

Gary H. Stern, president of the Minneapolis Federal Reserve Bank, said in an interview Monday that when he talks with bankers and business executives around his sprawling district, which runs from the Upper Peninsula of Michigan to the mountains of western Montana, "the tenor of the conversations is clearly more upbeat than they were at the turn of the year. It's not all bright and sunny, but the sense I got is that business is starting to improve." But Stern stressed: "I do not want to exaggerate this. . . . It is certainly not reflected in the current quarter's data. Will it be reflected in the third quarter? Who knows?"

What has added a sense of urgency to next week's policymaking session is the rapid, unexpected decline in the U.S. inflation rate this year. The core consumer price index, which excludes volatile food and energy prices, was up at only a 1 percent annual rate over the past three months. Another measure closely followed by many Fed officials, the core price index for personal consumption expenditures, rose at about the same 1 percent annual rate in the six months ended in March, and analysts are predicting a similar number for the current quarter.

The Fed's concern is the "minor probability" that this drop in the inflation rate could turn into a deflation, which Stern defined in a talk this week as "a sustained period of decline in a broad measure of prices." There is a consensus among policymakers that the probability of that happening "is low, but the consequences if we experience it possibly would be severe," he said. In a deflation, declining prices could force employers to reduce wages, make it harder for borrowers to repay debts, seriously hurt economic growth and make it more difficult for the central bank to use monetary policy to stimulate a slumping economy. That's because interest rates cannot effectively fall below zero. During a deflation, inflation-adjusted interest rates could therefore still be positive and restrain economic growth even when the nominal interest rate was zero.

Fed officials have said they could use other methods to pump money into the economy even if the overnight rate fell to zero. But Greenspan has said the lack of experience in dealing with such a situation means the Fed cannot be certain how things would work out, so it is far better to avoid a deflation in the first place. "The Fed is not panicking and believes the economy will pick up, most likely rendering the deflation issues less relevant in the longer run," said economist Peter E. Kretzmer at the Bank of America in New York. "Further, the Fed is confident it has the nonstandard tools to end a deflation." But Kretzmer, like many analysts, expects the Fed to lower rates next week, in part because the officials' recent statements about deflation have convinced financial markets such a cut is on the way. Balancing market expectations with some signs that the economy stabilized last month, the Fed is likely to lower the target by a quarter point, he predicted.

In contrast, economist Ken Kim at Stone & McCarthy, a financial market research firm, said he expects a half-point cut, given the notion of "insurance" behind the action and the absence of worry about excessive inflation.