The Fed's toughest foe: Deflation

NEW YORK (CNNMoney.com) -- Battling inflation has historically been a major aim of the Federal Reserve. But central bank policymakers now have an even bigger worry: deflation.

Prices have been slowing for three months. And members of the Federal Reserve openly voiced concerns about deflation at their last meeting.

The Fed now expects inflation of 1% or less this year and next, not including food and energy prices.

While spending less on purchases may sound appealing to consumers, falling prices and wages can cause much more economic pain than rising prices.

Businesses respond to declines in prices by cutting output and jobs. Why invest in making something to sell if the price you'll get for it will drop? Consumers hold back on buying for the same reason. The result is a downward spiral that can bring about a depression in a worst case scenario, or a prolonged period of economic stagnation, in the best case.

"It isn't that inflation in itself is a good thing. It's that the low inflation is a symptom of too little demand," said Scott Sumner, economics professor at Bentley University.

One of the biggest worries among economists is that fighting deflation is much tougher than turning back inflation.

With its key interest rate already near 0% for the last 18 months, the Fed can't cut rates to spur the economy.

Until a couple of months ago, most experts assumed the Fed's next step would be to raise rates in order to reduce the risk of inflation. The central bank's next moves are now less clear.

"There's a tried and true policy response to inflation -- raise interest rates and eventually you'll win," said Mark Zandi, chief economist for Moody's Analytics. "We haven't had a lot of bouts with deflation, but in those battles, central banks have never won in a clear-cut way."

In testimony Wednesday Fed Chairman Ben Bernanke said that while he believed inflation would be in check for the foreseeable future, he wasn't particularly worried about deflation taking hold.

But others argue the Fed has to be prepared to take unprecedented steps to spur economic activity and move prices higher, especially since Congress appears unwilling to pump more money into the economy and add to record deficits.

The Fed has traditionally been thought to favor an annual inflation rate close to 2%. Sumner recommends that the Fed set a target of 3%, which he said would signal to both investors and individuals that now is time to spend before prices go up.

According to Sumner, one of the biggest problems is that banks are hoarding too much cash. Banks are required to keep a certain amount of cash in reserve accounts at their local Federal Reserve bank. But right now they collectively have $1 trillion in excess reserves in those accounts. That's partly because the banks are worried about the economy and the ability of borrowers to repay loans. But the Fed also encourages them to do so by paying them 0.25% interest.

He suggests the Fed follow the lead of the Swedish central bank last year and establish a negative interest rate on those excess reserves, charging banks to keep excess cash, rather than paying them. That could encourage banks to push money out the door.

Other economists argue the problem isn't banks' willingness to lend, but rather weak demand because of the recession.

Mark Thoma, economics professor at the University of Oregon, said short of Bernanke's facetious suggestion back in 2003 that the Fed should drop money from helicopters, getting people spending again is beyond Fed's control.

"It's easy to choke off demand," he said. "But you can create all the incentives to spend you want, and it won't necessarily work."

Some are looking for the Fed to start pumping more money into the system by resuming purchases of mortgages and long-term treasuries as it did in 2009. It could even expand the assets it would purchase.

Zandi believes the Fed is looking at new steps it could take if deflation starts to take hold, including charging banks for excess reserves and purchases of new classes of assets, such as corporate debt and even stocks.

"Presumably they're thinking about these scenarios, thinking the unthinkable," he said. "Given what we're facing, it's a reasonable thing to do."