The Double Whammy: Deflation Tightens Monetary Policy for Fed

05-07-2010 • Bloomberg.com

Inflation that’s too low raises the possibility of outright deflation and doesn’t ease the real burden of debt, Bernanke said in a 2003 speech when he was a Fed governor. A falling inflation rate also increases real interest rates, effectively tightening monetary policy, he said. Measures compiled by the Fed’s regional banks show inflation already at record lows. The Dallas Fed’s so-called trimmed mean measure of inflation, which removes the most extreme increases and decreases, fell in 10 of the last 12 months to an annual rate of 1 percent in February and March. The Cleveland Fed’s Median CPI index increased at a 0.6 percent annual rate in March. The index reflects the median change in prices, rather than the weighted average of the traditional consumer price index. Money Supply Money supply also points to declining inflation. The broadest measure compiled by the Fed, known as M2, expanded at a 1.5 percent annual rate in March, down from a 9.2 percent rate a year earlier. “Central banks ignore money at their own peril,” said Gabriel Stein, a director at Lombard Street Research in London. “One of the key signals of threatening deflation is if money supply grows very slowly or in fact contracts.”