Deflation may be next big threat
Risk of sustained period of falling prices is growing
LONDON: As Federal Reserve chairman Ben Bernanke and his global colleagues 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 risk of a sustained period of falling prices is growing, especially if the patchwork of rescue and stimulus packages fails.
‘The ghost of deflation could be dragged out of the closet again in the coming months,’ Mr Joerg Kraemer, the chief economist at Commerzbank in London, said.
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 (ECB) president Jean-Claude Trichet and Bank of England governor Mervyn King may be forced to follow Mr Bernanke, whose Fed has chopped its benchmark rate by 3.25 percentage points since August last year to 2 per cent, its most aggressive round of easing in two decades.
The deflation scenario may go like this: Banks worldwide, stung by US$588 billion (S$852.4 billion) in write-downs related to toxic assets, especially mortgage-
related securities, will further cut credit flow, 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.
Mr Tony Tan, the deputy chairman of the Government of Singapore Investment Corporation, said: ‘A vicious deflationary cycle’ could then ensue.
Prices are already falling in parts of the world economy. Home values have dropped more than 10 per cent in the United Kingdom and the United States in the past year. Oil, copper and corn drove commodities towards their biggest weekly decline since at least 1956 on Oct 3. The Baltic Dry Index, a measure of commodity shipping costs, has dropped 75 per cent since May.
Mr Trichet said last week that European policymakers had considered reversing their July decision to raise the benchmark rate by a quarter point to 4.25 per cent. Most economists expected the Bank of England to cut its key rate by at least a quarter point on Thursday 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 the Fed’s rate to a 45-year low of 1 per cent and kept it there for a year, which critics said helped fuel the property and credit boom now unravelling.
This time, the crisis is an increasingly dysfunctional banking system that may be unable to continue making loans that grease economic activity. Such a pullback, combined with slowing growth and falling asset and commodity prices, makes deflation more of a threat, Mr David Owen, the chief European economist at Dresdner Kleinwort Group in London, said.
Spooked by the collapse of Lehman Brothers and other institutions, banks are restricting access to credit. The London interbank offered rate 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 Mr 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.
When credit markets started seizing up in August last year, Mr Bernanke set up US$1.4 trillion in emergency borrowing for financial institutions. The ECB, Bank of Japan and other central banks have set up similar lifelines. Last Friday, US President George W. Bush signed into law a US$700 billion bank rescue plan.
Mr Kraemer said the Fed might also consider further easing collateral requirements or purchases of government bonds ‘as a last resort’.
BLOOMBERG NEWS
Source : Straits Times - 07 Oct 2008
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