MSN Money's Mirhaydari: Fed Must Act Fast to Prevent Deflation Disaster

Thursday, 31 Oct 2013 01:42 PM

By Michael Kling

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The Federal Reserve must do more and do it fast before we fall into a 1990s-style Japanese deflation disaster, argues MSN Money columnist Anthony Mirhaydari in an article for MarketWatch.

The Fed is continuing to purchase $85 billion of bonds a month in an effort to bolster the economy by keeping rates low.

It's not enough, warns Mirhaydari, a former research analyst.

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He counts the troubling economic signs. Home sales plunged after 30-year mortgage rates jumped from 3.4 percent to 4.6 percent in May. Consumer sentiment hit a six-month low.

Core durable-goods slowed to the second-weakest rate since the end of the recession. Business inventories are growing. Estimates for fourth-quarter gross domestic product (GDP) growth have slid to 1.6 percent.

The dismal data indicate the Fed will maintain its quantitative easing for the time being. It also means quantitative easing (QE) may be failing to promote real economic growth.

The Fed has no easy way to exit. Its stimulus is no longer effective, but even talk about tapering squashed the real estate market, the most important leg of the economy.

Mirhaydari recommends that the Fed inject funds directly into the economy by funding public-private infrastructure investment trusts or converting its Treasury holdings into equity-like assets, which would essentially erase some of the national debt. It could convert long-term bonds into zero-coupon perpetuity bonds.

"In other words, the Fed needs to do more, and do it more aggressively and creatively than it is now. But we're running out of time," adding that more dovish Fed governors will retire and more hawkish regional bank presidents will rotate onto the policy-setting Federal Open Market Committee next year.

Other experts are also warning about the deflation threat.

As the Fed shrinks QE, the U.S. will face a "monetary cliff," a plunge from falling inflation to deflation more dangerous than the fiscal cliff it faced earlier this year, writes economist John H. Makin in a paper for the American Enterprise Institute. Investment, spending, lending and employment growth could all suffer horribly.

Even as some asset prices have risen, goods and services inflation has fallen. Yet the Fed may be slow to spot and react to the threat, he fears.

"Even as deflation threatens, widespread inflation fears persist, for some members of the FOMC and for markets."

The Fed will walk a fine line as it winds down QE, Makin says. If it tapers too fast it prompts deflation. If it moves too slowly it may spark inflation.

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