Editor's note: This column, which reflects market activity from the day before, originally appeared May 20 on RealMoney.com. To sign up for RealMoney, where you can read Tony Crescenzi's commentary every day, please click here for a free trial.

When the Federal Reserve delivered its policy statement after the May 6 Federal Open Market Committee meeting, investors interpreted it as an indication that the Fed was expressing new deflation worries. After all, the Fed's choice of words seemed to suggest as much:

"... the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level."

That statement ignited a significant rally in the Treasury market, with the yield on the 10-year Treasury note falling about 40 basis points to 3.40%, a 45-year low. It also put the public's attention squarely on the risks of deflation, and the markets and the media have kept an intense eye on the deflation threat ever since.

Mixed Signals

The Fed almost certainly had no intention of increasing deflation worries. Indeed, my Washington sources indicate that the Fed is actually quite optimistic about the economy and that the May 6 reference to the risk of deflation was meant to address concerns in the financial markets rather than a new concern of the Fed's. The Fed probably wanted to indicate that it was intent on preventing deflation and was simply delivering another in a series of assurances dating back to the end of 2002, when Fed Governor Ben Bernanke gave a watershed speech titled "Deflation: Making sure 'it' doesn't happen here."

As a result of the latest rampant deflation talk, the Fed will probably try to sharpen its message. Chairman Alan Greenspan will have an opportunity to do just that when he speaks on Capitol Hill before the Joint Economic Committee at 9:30 a.m. Wednesday to discuss the economic outlook. Greenspan seems more inclined to try to reduce deflation fears than to feed them. He surely knows that the deflation process can be substantially influenced by psychological factors and almost certainly wants to avoid doing anything that might add to speculation about the risks of deflation.

The Treasury Reaction

In downplaying deflation concerns, Greenspan has a delicate task at hand. Much of the recent Treasury market gains have been based on the notion that new deflation worries might prompt the Fed to take unusual steps to prevent deflation, including purchasing U.S. Treasuries in the open market. If Greenspan indicates that the Fed isn't very concerned about deflation, the Treasury market could react very negatively. Therefore, he might want to indicate that an interest-rate cut at the Fed's June 24-25 meeting is still possible, but that the cut would be geared to counter weakness in final demand rather than the risks of deflation.

If Greenspan instead chooses to reinforce the idea that the Fed is worried about the risks of deflation, Treasuries might continue to soar. Although a further decline in market interest rates might seem desirable, any further igniting of the deflation worry could add further anxieties into the equity and currency markets. This could cause considerable dislocation in the markets, which the Fed surely wants to avoid.

That's why it would be risky for Greenspan to do anything other than indicate that the Fed isn't worried about deflation -- but would act aggressively if the risk materialized.

Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. He appreciates your feedback and invites you to send it to Tony Crescenzi.

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