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Greenspan defends deflation worries Original Source Link: (May no longer be active)
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Business - AP
Greenspan Defends Deflation Worries
Fri Aug 29,10:40 AM ET
By MARTIN CRUTSINGER, AP Economics Writer
JACKSON, Wyo. - Federal Reserve (news - web sites) Chairman Alan Greenspan (news - web sites) on Friday defended the Fed's recent worries about deflation, which have sent financial markets on a roller coaster ride, saying it is the job of a central bank to guard against even remote risk of danger.
Greenspan said it was sometimes necessary for the Fed in its conduct of interest rate policy to take out an insurance policy "against the emergence of especially adverse outcomes."
He said that while the possibility of deflation was viewed as remote, the Fed needed to be alert to the possibility because the consequences could be so severe as it attempted to manage monetary policy in an always-uncertain environment.
"Uncertainty is not just an important feature of the monetary policy landscape, it is the defining characteristic of that landscape," Greenspan said in remarks that opened a two-day conference on monetary policy sponsored by the Federal Reserve Bank of Kansas City.
Greenspan and his colleagues began talking in earnest about the possibility of deflation, which they always characterized as remote, in the spring.
Defined as a destabilizing decline in prices, deflation is something that the United States has not seen since the Great Depression of the 1930s. In that episode, thousands of banks failed as borrowers were not able to pay back loans because of widespread job layoffs as companies, forced to slash the prices of their products, had to shed workers.
Greenspan's comments were seen as a defense of the central bank, which has come under criticism for sending misleading signals to financial markets with the result that long-term interest rates have been rising sharply in recent weeks, reflecting investor disappointment over Fed policy moves.
The Fed first mentioned the possibility of a sustained fall in inflation in its formal statement after its May meeting, and then Greenspan and other Fed officials talked about the possibility of using unconventional methods to combat the problem. The bond market reacted with a huge rally that pushed the benchmark 10-year Treasury note down to a more than four-decade low of 3.1 percent.
However, when the Fed at its June meeting cut its key interest rate by only a quarter-point, instead of the half-point that investors had hoped for, and made no mention of unconventional methods to lower interest rates further, bond prices began tumbling, sending various long-term interest rates surging.
Interest rates on 30-year mortgages, which had fallen to a low of 5.21 percent in mid-June, have jumped by more than a percentage point since that time, to 6.32 percent currently, according to Freddie Mac's weekly survey.
Greenspan did not specifically address the roller coaster ride the bond market has been on recently, nor did he give any hints about where the short-term interest rates that the Fed controls may be headed. Many economists believe the central bank will keep its target federal funds rate, the interest that banks charge each other, at a 45-year low of 1 percent for many months to come, in order to ensure that the current signs of a rebounding economy do not falter.
Greenspan said that central banks have to plan not only for the most likely economic outcome as judged by what their computer models tell them, but any number of other possible outcomes given how difficult it is to forecast the movements of a complex economy.
"The conduct of monetary policy in the United States at its core involves crucial elements of risk management, a process that requires an understanding of the many sources of risk and uncertainty that policymakers face," Greenspan said.
Greenspan offered examples of periods in the past when the Fed managed monetary policy to guard against the remote possibility of a very serious event. He said the rapid reduction of interest rates in the fall of 1998 at the height of the Asian and Russian financial crises was one such period.
"The product of a low-probability event and a severe outcome, should it occur, was judged a larger threat than the possible adverse consequences of insurance that might prove unnecessary," he said.
Greenspan, as he has done in the past, rejected the use of a device employed by some central banks in the world known as "inflation rate targeting," in which the central bank sets an optimal target for inflation for the year and then manages interest rate policy in an effect to achieve that target.
Greenspan said he continued to prefer a more flexible approach to policy-making rather than establishing an inflexible target.
"Rules by their nature are simple and when significant and shifting uncertainties exist in the economic environment, they cannot substitute for risk-management paradigms, which are far better suited to policymaking," he said.
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