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Why the Fed should worry about deflation

October 30, 2013: 5:00 AM ET

The Fed seems most concerned with inflation, but some economists see a bigger risk in prices declining.

Ben Bernanke

Ben Bernanke

FORTUNE -- As Federal Reserve policymakers wrap up their two-day meeting Wednesday, some have called on the central bank to do more to avoid threats of deflation.

Most don't like having to paying higher prices, and the Fed has long tried to stabilize the U.S. economy by keeping the general costs of everything from shelter to clothes from rising too rapidly. But as the New York Times noted over the weekend, a little inflation could be good for the economy, and there's growing concern inside and outside the Fed that inflation isn't rising fast enough.

Many are wondering if the Fed should worry more about deflation rather than inflation. After all, when the central bank launched its large-scale bond-buying program to stimulate the economy, many expected inflation would climb. As it turns out, that hasn't happened. Just take a look at the price of gold, typically a hedge against inflation. Prices have fallen by 19% so far this year.

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If disinflation leads the U.S. into deflation, it would certainly hurt the economy: Real interest rates would rise, potentially discouraging investing and spending; the value of debts would go up; job growth would slow. "Once an economy slips into deflation, the risks of a self-reinforcing deflationary spiral rises," according to a new paper by the American Enterprise Institute for Public Policy. The U.S. isn't alone, however. Over the past two years, European and Chinese inflation rates have drifted steadily lower. And even though Japan has tried hard to end 15 years of deflation, the world's third-largest economy has seen only modest relief.

In August, U.S. inflation rose just above its slowest pace at an annual pace to 1.2% -- below the Fed's target of 2% for keeping the economy growing in a healthy way. Deflation arises when the inflation rate falls into negative territory, so the U.S. is safe, at least for now. The question is for how long?

Such worries have further complicated one of the Fed's main jobs to keep prices stable. Some say that while the inflation rate hasn't risen as much as expected, the central bank could lose control of prices as the economy recovers. If and when that happens is another question confronting the Fed.

Perhaps, though, the Fed shouldn't wait. John Makin, economist at the American Enterprise Institute, urges the Fed to take steps now and offers advice for Janet Yellen, President Obama's nominee for the next Fed chair. He suggests extending the central bank's bond buying program and urges the incoming chair to discuss the risks of deflation "at some length."

More than that, Makin suggests an interesting way the Fed could guard against inflation and at the same time avoid deflation by lowering its inflation target. Currently, the central bank has a 2% target, and if inflation rises substantially above that it plans to tighten policy. Makin suggests lowering that target to 0.5% to 1.5%, signaling to investors that the Fed will not let the inflation rate fall below zero and cause the economy to spiral into deflation.

Of course, what the Fed might do next remains to be seen.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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