On November 21, 2002, Federal Reserve Chairman Ben Bernanke, then a member of the Board of Governors, gave a speech titled Deflation: Making Sure “It” Doesn’t Happen Here. This speech provides a niceÂ window into how the current Fed might react in a deflationary environment. In the speech Bernanke outlines why deflation is so damaging to an economy and some of the strategies that the Federal Reserve could use in order to avoid deflation. Some of these policies ended up beingÂ implemented from 2007 to 2009. In the speech Bernanke goes on to outline additional ways that the Fed might try to avoid deflation.
A broad decline in asset prices, known as deflation, wasÂ mostly avoided over the past two years, however,Â the most recent inflation figures indicate that, even with all the monetary and fiscal stimulus, inflation remains muted. From June 2009 to June 2010 the change in the consumer price index was only 1.1%. Stripping out the volatile prices for energy and food the change was 1.0%. To put these figures in context, the Federal Reserve, in order to meet one of its mandates of price stability, targets an inflation rate of 3.0%
In order to prop up aggregate demand and avoid deflation extraordinary monetary and fiscal policies were undertaken by the Federal Reserve and the federal government over the past two and a half years. On the monetary front the Fed first used traditional measures by dropping the Federal Funds rate (the rate at which large institutionsÂ loan to each other on aÂ short term basis)Â to a range of 0.00% to 0.25%. This had the effect of lowering interest rates forÂ both consumers and business borrowers. The Fed then turned to less ordinary measures such as purchasing U.S. Treasuries, U.S. federal agency debt and mortgage backed securities. The extraordinary fiscal policies included the Troubled Asset Relief Program (TARP) which recapitalized banks and the American Recovery and Reinvestment Act of 2009.Â The primary reason why the Fed and the federal government undertook these actionsÂ was to avoid deflation.Â Widespread deflation can be very damaging to a nation’s economy.Â In order to understand why deflation is so destructive ABC NewsÂ had a short segment onÂ the economic consequences of this phenomenon.