December 2009 inflation data showed the U.S. Consumer Price Index rising at an annual rate of 2.7 percent over the preceding 12 months. After several months of negative numbers earlier in the year, it appears that the threat of deflation has receded.
Just a few months ago, some economists were more pessimistic. When the economy enters a severe recession, conventional monetary policy can lose effectiveness. As interest rates fall to near-zero, banks tend to accumulate excess reserves. At the same time, velocity may slow down. As a result, the link between monetary policy instruments and GDP weakens, and the central bank finds itself "pushing on a string."
In 2002, Ben Bernanke, then a newly-appointed Fed governor, dealt with these issues in a speech entitled "Deflation: Making Sure 'It' Doesn't Happen Here." In the speech, he proposed that if a threat of deflation ever did loom, the Fed could maintain effectiveness of monetary policy by taking unconventional actions, including buying longer-term securities and extending loans to financial institutions outside the commercial banking system. He was confident that if the Fed was bold enough to use all the tools at its disposal, "It"--Japanese-style sustained deflation--could not happen in the United States.
Now that the Fed appears to have saved us from the threat of deflation, it must turn its attention to finding an "exit strategy" for reabsorbing the massive quantity of liquidity it has injected into the financial system. Already, the Fed has begun to unwind some of its positions, but bank reserves are still extraordinarily high. More work remains to be done to make sure the economy does not come out of recession straight into inflation.
Click here to download a free set of PowerPoint slides that show the lastest inflation data and highlights of monetary policy over the last two years. If you find them useful in your economics course, please post a comment or send me an e-mail. I'd like to know how you use this material, and what you'd like to see next.