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The Fed's great something-flation debate

chart_ws_bond_10yearyield.top(7).pngThe fact that the yield on the 10-year Treasury is below 3% is a sign that investors are not concerned about inflation. Click the chart for more bond and interest rates. By Paul R. La Monica, editor at large

NEW YORK (CNNMoney.com) -- With the economic recovery starting to lose steam, the Federal Reserve has the unenviable task of trying to figure out which "flation" battle to fight. Inflation or deflation?

The Fed will hopefully provide more clues following its policy meeting Tuesday. It's all but certain the central bank will once again leave its benchmark federal funds rate in a range of 0 to 0.25% - the range it has maintained since December 2008.


What's not as clear, however, is what the Fed might say about the economy and what it plans to do to combat its slowing momentum.

The Fed's official party line for months has been that inflation is not a concern. In the statement following its last meeting in June, the Fed reiterated that longer-term inflation expectations are "stable" and that "inflation is likely to be subdued for some time."

But according to the minutes of that meeting, "a few participants cited some risk of deflation." That's the risk that prices fall at a persistent rate, which tends to lead to reduced business production, higher unemployment and lower wages.

St. Louis Federal Reserve president James Bullard, who is currently a member of the Fed's policy-setting committee, wrote a paper last month warning that the probability has increased for a "Japanese-style deflationary outcome for the U.S. within the next several years" if the Fed did not start buying more Treasurys again.

Despite the rising deflation fears, economists said the chances of the Fed dropping a D-bomb in Tuesday's statement are highly unlikely.

"If I were in Las Vegas, I'd have to get some pretty big odds to bet that the D word would be in the statement," said Terry Clower, director of the Center for Economic Development and Research at the University of North Texas.

Clower said investors are already spooked by deflation worries. Mentioning deflation could be self-defeating since the Fed could cause more deflationary pressure if it said something that sent stock prices and long-term bond yields tumbling.

"It would be unusual for the Fed to put that kind of fear in the market. It almost could be a self-fulfilling prophecy," he said.

Clower said deflation seems to be a popular economic buzzword of late, but he does not think it's the Fed's biggest problem.

John Stoltzfus, senior market strategist with Ticonderoga Securities in New York, agreed. He said the Fed, along with other central banks such as the European Central Bank, appear to be doing a good job of acting in tandem to ensure that the global recovery remains on track. The ECB held rates steady at 1% Thursday.

Stoltzfus added that it's hard to imagine a deflation problem as long as China's economy is growing as rapidly as it is.

"The concerted efforts of central banks and demand from emerging markets - where there are inflation risks - do offset deflation fears," he said.

With that in mind, some believe the Fed should spend less time worrying about short-term deflation scares and more about the potential for longer-term inflation problems.

The Fed did indicate in the minutes of the June meeting that "a few participants noted the possibility that a potentially unsustainable fiscal position and the size of the Federal Reserve's balance sheet could boost inflation expectations and actual inflation over time."

That's problematic. The possibility of prices rising before the job market and housing markets rebound raises the specter of stagflation, the combination of a weak economy and high prices, particularly for commodities such as oil. The U.S. briefly flirted with a period of stagflation in the summer of 2008 when the economy was rapidly slowing and gas prices were at record highs.

But some economists have even worse fears. Because the Fed has essentially turned on the printing press to try and stimulate the U.S. out of the economic morass, those economists believe the ultimate cost will be a worthless dollar and runaway inflation or hyperinflation.

Those concerns are likely overblown. Keith Hembre, chief economist for First American Funds in Minneapolis, said the combination of tight credit conditions and an anemic jobs market gives the Fed leeway to sit tight and not make any significant changes to its policy anytime soon.

"I suspect the Fed will continue to say inflation remains subdued," he said. "Even with the Fed's balance sheet expansion, there is no inflation threat for the foreseeable future and there won't be for several quarters.

That's probably true. But it would be a mistake for the Fed to ignore the possibility of inflation at some point down the road.

"When the economy finally turns the corner for good, you could certainly see pricing pressures. There is a scenario where inflation could be an issue. It's not evident now, but it's more likely than deflation," Clower said.

- The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney.com, La Monica does not own positions in any individual stocks.  To top of page

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