Thursday, November 18, 2010

Bernanke Defending Policy at Senate

Bloomberg reported on Bernanke's defense of monetary policy at a closed meeting with senators. The response from senators was predictable and uninteresting. Buried at the end of the report was the most important piece of information. They reported that the core inflation rate in the US was only .6% year to year in October. This is the lowest post war inflation rate recorded in the US. We call the reduction in the inflation rate disinflation. If it falls into negative territory it is call deflation. That, of course, is what the majority in the Fed are worried about. The goal of monetary policy is to avoid deflation. The Fed is skilled at controlling inflation. Deflation is much more difficult to control once it gets started. After all, we have a recession when there is not enough spending in the economy to absorb the output of a full-employment economy. That is why we have unemployment. Business investment is targeted to create the output consumers intend to purchase. The problem with deflation is that money becomes more valuable when prices fall. Consumers hold on to money instead of spending it. It also affects debtors negatively. They have to pay back their mortgages with more valuable dollars. This would not be good for the housing market.

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