Deflation may be next threat

WASHINGTON - As countries around the world fight the worst financial crisis since the 1930s, one danger is looming larger by the day: deflation.

With asset markets tumbling, commodity prices plunging the most in 50 years and banks keeping a tighter grip on credit, the ingredients for a sustained period of falling prices are coalescing, Bloomberg News reported on Monday.

While inflation is still a concern for many policy makers only months after oil and food prices peaked, the risk is their patchwork of rescue and stimulus packages will fail, and prices will start to fall throughout the broader economy.

'The ghost of deflation could be dragged out of the closet again in coming months,' says Mr Joerg Kraemer, chief economist at Commerzbank AG in London.

A global recession is already looking more likely, with the credit freeze stirring memories of Japan's decade-long struggle with deflation in the 1990s. So European Central Bank President Jean-Claude Trichet and Bank of England Governor Mervyn King may be forced to follow Bernanke, whose Fed has chopped its benchmark rate by 3.25 percentage points since August 2007 to 2 per cent - its most aggressive round of easing in two decades.

According to Bloomberg, the deflation scenario might go like this: Banks worldwide, stung by $588 billion (S$815.3 billion) in writedowns related to toxic assets - especially mortgage-related securities - will further reduce the flow of credit, strangling growth. That will push house prices lower, forcing additional losses and making banks even more reluctant to lend.

As the credit crisis worsens, businesses will find it almost impossible to raise prices.

Prices are already falling in parts of the world economy. Home values dropped more than 10 per cent in the UK and in the US in the past year.

Oil, copper and corn drove commodities toward their biggest weekly decline since at least 1956 on Oct 3, with the Reuters/Jefferies CRB Index of 19 raw materials tumbling 10.4 per cent. The Baltic Dry Index, a measure of commodity shipping costs, has dropped 75 per cent since May.

'We are certainly more worried about deflation than inflation,' says Mr David Owen, chief European economist at Dresdner Kleinwort Group Ltd in London. Central bankers need to 'get rates down and keep them there for quite some time', he says.

Aggressive Easing
Mr Trichet said Oct 2 that European policy makers have considered reversing their decision in July to raise their benchmark rate by a quarter point to 4.25 per cent. Forty-six of the 61 economists surveyed by Bloomberg News expect the Bank of England to cut its key rate by at least a quarter point Oct 9 from 5 per cent.

The Fed has already responded to one deflationary scare this decade. With inflation approaching 1 per cent in 2003, then- Chairman Alan Greenspan slashed its rate to a 45-year low of 1 per cent and kept it there for a year, which its critics say helped fuel the property and credit boom that is now unraveling.

This time, the crisis is an increasingly dysfunctional banking system that may not be able to continue making loans that grease economic activity, said Bloomberg.

Such a pullback, combined with slowing growth and falling asset and commodity prices, makes deflation more of a threat, Owen says.

Restricting Credit
Spooked by the collapse of Lehman Brothers Holdings Inc and other institutions, banks are restricting access to credit. The London interbank offered rate, or Libor, they charge each other for three-month loans in dollars rose to 4.33 per cent on Oct, 3, the highest since January.

Not all economists share Owen's gloomy outlook. Some say Mr Bernanke and other central bankers have learned the lessons of Japan and the Great Depression so well they will do everything necessary to head off trouble.

Former Fed Governor Lyle Gramley says that while deflation is a risk 'if we were to go into a very, very prolonged recession and nobody did anything about it,' he is 'not worried', because he's confident the Fed will act 'very, very, very aggressively'.

Commerzbank's Kraemer says the Fed might also consider further easing collateral requirements or purchases of government bonds 'as a last resort'.

Mr Kraemer says he thinks a slowdown in inflation is more likely than deflation. The surge in commodity prices earlier this year drove inflation in the US, Europe and Asia to the strongest pace in at least a decade. Strategists have pointed to Paulson's rescue plan as an additional risk.

Japanese core consumer prices, which exclude fresh food, climbed 2.4 per cent in August from August 2007. The US core rate, which strips out food and energy, rose 2.5 per cent from a year earlier.

Still, deflationary forces are mounting in the US and other parts of the world economy, said Bloomberg. In Britain, the Nationwide Building Society says house prices have dropped 12.4 per cent in the past year as banks restrict the supply of mortgages, putting the economy on course for its first recession since the early 1990s.

Deflationary Consequences
'The risk we must be careful not to underestimate is the deflationary consequences of the credit crisis,' Bank of England Deputy Governor John Gieve said last month.

In the US, prices manufacturers paid for materials last month plunged the most since at least 1948, with the Institute for Supply Management's index dropping 23.5 points to 53.5 points.

The breakeven rate on US 10-year Treasuries, a measure of price expectations, dropped to 1.5 per cent from 2.6 per cent in July. Japan is the only country whose bond market implies a lower inflation rate than the US.

All this is likely to make the Fed resume rate cuts, says Mr Robert Dye, a senior economist at PNC Financial Services Group in Pittsburgh, Pennsylvania.

'If we're going over a cliff, we're not going to go over a cliff with a 2 per cent federal funds rate,' he says. 'What's the point of holding back?'


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