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It was this deflation scare that prompted then Fed chairman Alan Greenspan to sharply lower
interest rates. In 2002 the average Federal Funds effective rate was 1.67 percent, then the lowest in
forty-four years. In 2003 the average Federal Funds rate was even lower, 1.13 percent, and it
remained low through 2004, averaging 1.35 percent for the year. The extraordinarily low interest-ratepolicy during this three-year period was designed to fend off deflation, and it worked. After the usual
lag, the consumer price index rose 2.7 percent in 2004 and 3.4 percent in 2005. Greenspan was like
the pilot of a crashing plane who pulls the aircraft out of a nosedive just before it hits the ground,
stabilizes the aerodynamics, then regains altitude. By 2007, inflation was back over 4 percent, and the
Fed Funds rate was over 5 percent.
Greenspan had fended off the deflation dragon, but in so doing he had created a worse conundrum.
His low-rate policy led directly to an asset bubble in housing, which crashed with devastating impact
in late 2007, marking the start of a new depression. Within a year, declining asset values, evaporating
liquidity, and lost confidence produced the Panic of 2008, in which tens of trillions of dollars in
paper wealth disappeared seemingly overnight.
The Federal Reserve chairmanship passed from Alan Greenspan to Ben Bernanke in February
2006, just as the housing calamity was starting to unfold. Bernanke inherited Greenspan’s deflation
problem, which had never really gone away but had been masked by the 2002–4 easy-money policies.
The consumer price index reached an interim peak in July 2008, then fell sharply for the remainder of
that year. Annual inflation year over year from 2008 to 2009 actually dropped for the first time since
1955; inflation was turning to deflation again.
This time the cause was not the Chinese but deleveraging. The housing market collapse in 2007
destroyed the collateral value behind $1 trillion in subprime and other low-quality mortgages, and
trillions of dollars more in derivatives based on those mortgages also collapsed in value. The Panic
of 2008 forced financial firms and leveraged investors to sell assets in a disorderly fire sale to pay
down debt. Other assets came on the market due to insolvencies such as Bear Stearns, Lehman
Brothers, and AIG. The financial panic spread to the real economy as housing starts ground to a halt
and construction jobs disappeared. Unemployment spiked, which was another boost to deflation.
Inflation dropped to 1.6 percent in 2010, identical to the 1.6 percent rate that had spooked Greenspan
in 2001. Bernanke’s response to the looming threat from deflation was even more aggressive than
Greenspan’s response to the same threat almost a decade earlier. Bernanke lowered the effective Fed
Funds rate to close to zero in 2008, where it has remained ever since.
The world is witnessing a climactic battle between deflation and inflation. The deflation is
endogenous, derived from emerging markets’ productivity, demographic shifts, and balance sheet
deleveraging. The inflation is exogenous, coming from central bank interest-rate policy and money
printing. Price index time series are not mere data points; they are more like a seismograph that
measures tectonic plates pushing against each other on a fault line. Often the fault line is quiet, almost
still. At other times it is active, as pressure builds and one plate pushes under another. Inflation was
relatively active in 2011 as the year-over-year increase reached 3.2 percent. Deflation got the upper
hand in late 2012; a four-month stretch from September to December 2012 produced a steady decline
in the consumer price index. The economy is neither in an inflationary nor a deflationary mode; it is
experiencing both at the same time from different causes; price indexes reveal how these offsetting
forces are playing out.