A 99-Cent Hamburger Isn't Deflation

Inflation Math

And if inflation sinks to 0, then the real rate is the same as the 1.25% charged by the Federal Reserve.

The real trouble happens, though, as the Federal Reserve or any other central bank cuts interest rates to 0% in a 0% inflation environment. As the Japanese banks have proved beyond a reasonable doubt, in this situation there's no incentive to increase borrowing from the central bank or to increase lending. At that point, the central bank's monetary tools have lost all power to move the economy.

Does all this mean that the Federal Reserve knows that an economywide deflation is coming? I don't think so. The Federal Reserve certainly sees economywide deflation as a possibility -- a remote one, in fact, if we can believe the public statements of Federal Reserve members.

In my opinion, the Federal Reserve's actions are founded not on a belief that deflation is coming, but out of a conviction that this is the time to exert maximum leverage. There are two parts to that conviction. First, there's the Federal Reserve's study of the Japanese economic quagmire, concluding that the big mistake was waiting to cut rates until the deflationary momentum was fully established. It's almost impossible to stop deflation once the trend is in place, so it's best to act early and boldly, the Federal Reserve has concluded. It's better to err on the side of excessive cutting than to let deflation get established.

Second, by cutting rates now and maybe again early in 2003, the Federal Reserve gets to make maximum use of whatever inflation still lingers in the economy. Why wait until inflation falls even lower to cut interest rates since that decreases the leverage of the cuts that come from a big spread between real and nominal interest rates? The ability to create negative real interest rates is a powerful tool that can be put to use now and that might not be available if the central bankers wait.

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