Fed official: Deflation could impact bank earnings

Northwestern Financial Review, Jul 15-Jul 31, 2003 by Dullum, Justin

With the Federal Reserve keeping interest rates at historic lows, deflation is unlikely, said Gary Stern, president of the Federal Reserve Bank of Minneapolis.

Stern would not rule out deflation, however, and said small to medium-size businesses and their lenders would potentially be hit the hardest in the event of rapid, unanticipated deflation. Stern defined deflation as a sustained period of decline in a broad measure of prices.

"Unanticipated deflation, such as occurred in Japan, is more likely to result in arbitrary redistributions of income and wealth," said Stern in a June 16 address in Minneapolis. "It transfers income to creditors from lenders. Another way of putting it is lenders find themselves paying higher real interest rates than they expected."

Stern said mortgages and credit cards are good examples of markets with less exposure to deflation. "These areas work sufficiently well to eliminate these arbitrary redistributions," said Stern. "Why? Because you can always refinance or re-contract. The effect of that is people wind up paying and receiving the same real interest rate. That seems less true on the corporate side."

Issuers of corporate bonds without call provisions could get bit by deflation, said Stern. "And there's not a heck of a lot you can do about it until that paper matures," said Stern, adding that if a business misjudges the rate of price change and revenue growth "it may find itself with a debt burden that is more difficult to contend with than anticipated."

Economists remain somewhat mystified by the cause of deflation, said Stern, in large part because the United States has not dealt with broad price drops since the Depression. Prior to that, the only extended period of deflation occurred between 1875 and 1900. Stern drew a loose analogy between turn-of-the-century deflation in the United States to the modern deflation experienced by China.

"China has been the beneficiary of what we economists call a positive supply shot," said Stern. "In normal terms, that means you get more output of goods and services with the same inputs." Because its underlying cause is positive, Stern called "supply shot" deflation benign compared to the deflation witnessed in Japan over the last decade, which has been a consequence of less positive economic trends.

Stern offered two explanations for what causes deflation like that in Japan: Mistaken monetary policy and devoting too many resources to contracting industries. In the case of the Japanese, both situations were in play. "These two explanations go hand in hand," Stern said. "Economists will argue more for one over the other, but I believe they are mutually exclusive."

Stern said the U.S. has steered away from these conditions and praised the banking industry for remaining strong during a time in which faltering banks could have been disastrous.