Deflation

July 22, 2010 by Scott.

What happens if interest rates remain low for to long?  Expectations on future prices begin to be lowered and incentives to build inventory decrease.  Why build inventory when prices will be lower next month?  Low inventory creation reduces the need for workers and increases unemployment.  The deflationary cycle begins and feeds itself. Interest rates remain low and go lower as business parks cash and the Banks park cash at the Federal reserve.  Heck, at least the money being parked is ‘Safe’.  Add to this the ability of the Banks to borrow cheaply from the Fed and charge exorbitant rates to customers and the psychological impact is easy to see.  Demand slows, inventories get worked down, unemployment increases and the spiral can be come a deep recession or even a depression.  So whats’ a Fed to do?  Good question.  The Fed could buy assets and create the illusion of higher prices. But this expands the Fed balance sheet and increases the deficit.  There is very little political appetite to grow the deficit even further.  The Fed could lower rates to the point where they are actually negative.  Then the Banks would be charged to park their excess reserves.  Problem with that is the Banks would also stop paying interest on the most liquid of accounts hurting millions of savers.  The Fed could try to re-inflate the economy by raising rates and repurchasing it’s own debt.  Again this increases the deficit.  So what is the answer?  Anyone want to help?

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