Now it is up to the bond market.

(From Business Line)

Byline: V. Anantha Nageswaran

THROUGHOUT April and May, the US Federal Reserve officials talked up the threat of deflation and promised to counter it by purchasing Treasury bonds. Deflation is a state of affairs in which the general level of prices declines continuously. It has been happening in Japan since 1998. Why should any central bank be worried by deflation? In popular imagination, deflation appears to be an attractive proposition. Continuously falling prices must be good for consumers?

Why central bankers dread deflation more than inflation?

In reality, if all of us expect prices to be lower tomorrow than today always, we would postpone purchases today, every day. Demand would slump. Producers and wholesalers would incur losses and hence may have to shut down businesses. No fresh investment activity would take place. Hence, deflation could depress economic activity. Thus, unlike inflation, deflation could turn out to be self-perpetuating.

Second, central bankers in the industrialised world are quite familiar with inflation (rising prices). It is easier to tame inflation by rising interest rates, curbing credit and demand and thus cool down the economy. There is no ceiling on how much interest rates can be raised to fight inflation. However, deflation is a different beast. It is fought with low and falling interest rates. But interest rates cannot go below zero. Further, once an economy gets used to low and falling interest rates, the level of debt would steadily increase in such a scenario. Hence, a natural and persistent argument against rising interest rates at any …