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IMF Economists Warn of Deflation Threat to Global Economy - 2003-05-30

Economists at the International Monetary Fund say they consider deflation a threat to the global economy, but find the danger more menacing in Japan and Germany than in the United States.

An IMF task force concludes that the risk of deflation fall in the price level is greatest in Japan, Hong Kong, Taiwan and Germany. Responding to the the IMF report, Laurence Ball, an economics professor at Baltimore's Johns Hopkins University, worries that deflation could take hold in Germany because the government no longer has the tools needed to combat it. "Clearly what Germany needs is a monetary easing and they can't do that," he said. "And of course the problem is not that interest rates have hit the zero boundary. The problem is that there isn't a German interest rate that the German central bank controls. But it amounts to the same thing, we don't have the usual interest rate tool to apply to Germany."

Germany's interest rate is set by the European Central Bank, which determines monetary policy for all 12 countries using the euro currency. The problem, says Professor Ball, is aggravated because Germany is constrained [by European Union accord] from boosting government spending to stimulate consumer demand.

Kim Schoenholtz, chief economist at Citigroup Global Markets, agrees with IMF and Federal Reserve experts that deflation is less likely to occur in the United States. He said U.S. deflationary risks have diminished in the last six months. "Since that time the war in Iraq has come and gone. The oil spike has receded," he said. "And U.S. financial conditions have improved sharply, partly in response to the massive policy stimulus in place. The broad equity market has jumped by more than 20%. The rally in corporate bond spreads has been the largest in decades. Mortgage rates have touched two generation lows. And the trade weighted dollar has lost more than 10% versus major currencies."

In addition, he says, there has been an enormous fiscal stimulus and most consumers expect prices to rise in the months ahead. The experts agreed that deflation tends to occur in the aftermath of the collapse of an asset price bubble and when there is weakness in the financial system. Japan, and to a lesser extent Hong Kong, have been caught in a deflationary spiral for four years.