Colin Barr

Following the money in banking, economics, and Washington

Fed's Hoenig doubts deflation diagnosis

August 13, 2010: 12:32 PM ET

The Fed's most vocal hawk questioned the now-popular notion that the U.S. economy faces a deflationary bust.

Thomas Hoenig, the president of the Federal Reserve Bank of Kansas City, renewed his call for the Fed to end its promises to hold down interest rates.

He said in a speech Friday that the Fed's promise to keep its short-term interest rate target near zero isn't aiding the economic recovery, which he contends is stronger than commonly believed.

This trend isn't Hoenig's friend

"In fact, we are experiencing a better pace of recovery this time than at this point in our previous two economic recoveries," Hoenig said. "The current recovery in its first year saw GDP grow an average of 3.2%. The GDP growth rate for the 1991 recovery was 2.61%; and for the 2001 recovery, it was 1.92%."

What's more, Hoenig said, the promise to keep short-term interest rates near zero risks "inadvertently adding to 'uncertainty'" that tends to reduce consumption and business investment.

It also puts the Fed on the path to repeating the errors it made in the last recovery, when then Chairman Alan Greenspan kept the fed funds rate at 1% even as the economy expanded at high single-digit rates, he said.

The remarks come as policymakers grapple with persistently high unemployment and popular frustration that the economic rebound hasn't been stronger.

"There may be ways to accelerate GDP growth, but in my view, highly expansionary monetary policy is not a good option," Hoenig said. "Remember, high interest rates did not cause the financial crisis or the recession."

The comments come days after the Fed, expressing growing concern about the economic outlook, unveiled a plan to buy more Treasury bonds with the proceeds of maturing mortgage bonds. The Fed did so to make sure that the money supply wouldn't start contracting at a time when cash-strapped states are cutting spending to close their budget gaps.

That plan, together with Fed chief Ben Bernanke's remark last month that the economic outlook is "unusually uncertain," pushed investors out of riskier assets like stocks and into the safety of U.S. government bonds. The yield on the 10-year Treasury note has dropped as low as 2.7%, from 4% just four months ago.

The plunge has amplified worries that the economy is stumbling into a period of deflation, marked by a falling price level that increases consumers' debt burden.

But Hoenig noted that news reports were full of similar claims in the early stages of the last recovery, and said a look at the consumer price index over time should allay fears about price declines.

The consumer price index was a mere 18 in 1945 but was 172 at the start of this century. Today, despite our most recent crisis, the CPI is over 219. Not once during more than half a century has the index systematically declined. I find no evidence that deflation is the most serious threat to the recovery today.

Hoenig stressed that he isn't calling for an interest-rate rise now. Instead, he recommends that the Fed drop its promise to keep rates low for an extended period and then begin raising rates as the recovery picks up steam.

Hoenig, who is one of the 10 voting members of the Federal Open Market Committee this year, has been making that case for some time, to no apparent avail.

Hoenig also warned that policymakers, while recognizing the risks of surprising market players and leading to unrest, should be wary of giving traders a free pass, as he contends the Fed is doing now.

"I wish free money was really free and that there was a painless way to move from severe recession and high leverage to robust and sustainable economic growth," he said, "but there is no short cut."

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Colin Barr
Colin Barr
Senior Writer, Fortune

Colin Barr has covered finance for since November 2007. Previously he was a writer and editor for, winning a 2006 Society of American Business Editors and Writers award for "The Five Dumbest Things on Wall Street," and for Dow Jones Newswires. He is a 1991 graduate of Penn State and lives in Port Washington, N.Y., with his wife Meena Bose and their two kids.

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