Inflation

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rialized countries this year will hit 1.4%, its lowest level in more than 40 years.

Fed officials and most private economists still think deflation is highly unlikely. While the Fed is expected to cut rates either today or in December, that's more out of concern about slow growth, not deflation. Most Fed officials feel that the 1.75 points of rate-cutting room they have left is plenty to get the economy growing briskly again.

Still, they are all thinking more about deflation. "Whereas this possibility wasn't even on radar screens in past recoveries, it is in the range of plausible risks now," Al Broaddus, president of the Federal Reserve Bank of Richmond said last month. "We need to be alert to this risk."

Shouldn't consumers be happy when prices fall? That depends on what causes deflation. When technological progress leads to rising productivity, or output per hour of work, the economy can produce more each year with the same workers and equipment, and companies can cut prices while increasing sales. Between 1865 and 1879, manufacturing output rose 6% a year while prices fell by 3% a year. Wages were basically unchanged.

Deflation is more worrisome when it results from declining demand, as it did during the Great Depression when prices tumbled 24% between 1929 and 1933, bankruptcies mounted, thousands of banks failed and the unemployment rate hit 25%.

It is a central banker's nightmare. William McDonough, the 68-year-old president of the Federal Reserve Bank of New York, recalls his father taking him in the late 1930s to see breadlines and "people in jail who were there for stealing food for their families." The Depression, he said in a speech in March, "was a very real thing to the people who created the Federal Reserve's mandate and they never wanted it to happen again."

The 1930s demonstrate that deflation is most dangerous when debt burdens are heavy, as they were in the 1920s and are today. "When a deflation occu...