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Fed tries to turn conversation away from deflation risk

June 24, 2009 |  4:15 pm

At least we can stop worrying about deflation -- or so the Federal Reserve appears to be saying today.

In its post-meeting statement, the Fed removed a passage it had used after its three previous meetings to warn of the risk of deflation, meaning a broad-based decline in prices. Deflation is closely linked with another "D" word: depression.

The old statement wording read, "The Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term."

That was code for deflation.

Fedhq Today’s statement, which strikes a more upbeat tone about the economy overall, says the Fed "expects that inflation will remain subdued for some time."

One of the greatest fears since the economy and financial markets plunged off a cliff last fall was that the U.S., and maybe the world, would fall into a deflationary cycle -- a vicious spiral of falling prices and falling wages. Deflation feeds on itself by encouraging consumers to put off purchases, figuring things will only get cheaper (which, of course, is what happened with housing).

Some level of inflation is always preferable to a broad-based deflation, as poor Japan showed the world in the late 1990s and early part of this decade.

It’s in the Fed’s interest to try to banish deflation talk, and let investors, and consumers, focus on the possibility of rising inflation, assuming the economy turns around soon.

But some economists say it’s premature to think deflation is no longer a serious risk.

"The dramatic slowing in wage gains, which has much further to run, means that deflation is much more likely than rising inflation over the next couple of years," Ian Shepherdson, chief U.S. economist at High Frequency Economics, said in a note to clients.

Steven Ricchiuto, chief economist at Mizuho Securities USA, agrees. The huge amount of slack in the economy -- as evidenced by soaring unemployment and record-low factory utilization rates -- shows that "the fundamentals are clearly tilted towards deflation," he said.

If you believe in deflation, forget the stock market and commodities. A 10-year Treasury note paying an annualized 3.69% yield might turn out to be a fantastic investment.

-- Tom Petruno

Photo: The Federal Reserve building in Washington. Credit: Karen Bleier / AFP Getty Images