The Federal Reserve and federal government should maintain policies that stimulate the US economy until unemployment begins to retreat and the threat of a destructive downward cycle of prices known as deflation recedes, Eric Rosengren, president of the Federal Reserve Band of Boston, said today.
Rosengren, addressing the Greater Boston Chamber of Commerce, said that policy makers risk undermining a fragile recovery if they move too soon to raise interest rates, eliminate Fed lending programs, cut federal spending, or raise taxes to reduce the federal deficit.
After suffering a severe banking crisis and recession in the 1990s, for example, the Japanese government raised taxes to reduce deficits as soon as the first signs of a recovery appeared, Rosengren said. The result was another recession and an extended period of deflation.
Deflation, which marked the Great Depression, occurs when the economy is so weak that there is little demand for goods. Businesses slash prices to attract buyers, who stay on the sidelines waiting for prices to fall further. Inventories build, businesses cut production, and more workers lose jobs. Consumers cut spending more, and the cycle repeats.
“It is important that monetary and fiscal policy continue to support the economy until private sector spending has resumed, and until we are confident that the recovery will continue once the programs that have supported the economy over the past year are removed,” Rosengren said. “We need to be sure the economy continues on a path that will bring the unemployment rate down.”
Following last year’s financial crisis and economic free fall, the Fed slashed its benchmark interest rate to near zero and pumped more than $1 trillion into the economy through various programs, including the purchase of government and mortgage backed securities. The federal government, meanwhile, is running up $1 trillion-plus deficits to cover the costs of financial bailout and stimulus spending programs.
Many economists have raised concerns that these policies could spark an inflationary cycle if they are kept in place too long. The danger comes if demand starts to grow too quickly and rapidly drive up prices.
Rosengren, however, said falling prices remain a greater danger than rising ones. The economy, while recovering, remains weak. Inflation as measured by the core personal consumption expenditure index, a benchmark preferred by the Fed, is running at 1.3 percent a year, well below policy makers’ comfort zone of about 2 percent.
Lending has improved, but not returned to normal, Rosengren said. Falling commercial real estate prices and rising loan delinquencies pose new problems for banks. The unemployment rate, approaching 10 percent, is cutting incomes and holding down wages. US households, meanwhile, have yet to recover from stock market and housing crashes, further restraining consumer spending.
These conditions suggest that policy makers should maintain stimulative policies until the recovery gains traction, Rosengren said.
“Despite the many positive signs, we are seeing in the economy, the financial markets and the real economy need more time to heal,” Rosengren said. “In particular, we need the economy to grow rapidly enough that unemployment falls substantially and inflation settles at a rate near 2 percent.”
By Robert Gavin – Globe Staff
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