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Nightmare scenario: U.S. deflation risks rising

Nightmare scenario: U.S. deflation risks rising
On Wednesday October 26, 2011, 4:19 pm EDT
By Jason Lange

WASHINGTON (Reuters) – Risks are rising that a moribund job market and potentially steep drop in inflation could push the United States into a downward spiral of falling wages and prices.

That nightmare scenario of deflation might seem remote considering a recent rebound in growth, and the Federal Reserve would almost certainly try to head it off, probably well before prices started to fall.

But some investors and economists say the risk is real.

Inflation is expected to more than halve over the next year as a spike in prices for goods like oil and grains unwinds. Unemployment, meanwhile, will likely hold at nearly double its pre-recession level well into next year, keeping incomes under pressure.

If forecasts are correct, that could present a dangerous combination the Fed might not allow to brew for very long.

“You run the models and that all points to deflation,” said Joshua Dennerlein, an economist at Bank of America Merrill Lynch in New York. “Without some kind of monetary policy help you would definitely get deflation.”

Already, many forecasts for price increases are lower than they were a year ago when the Fed announced it would pump $600 billion into the banking system to boost growth and counter fears of deflation, which were growing at the time.

The inflation rate, which hit a three-year high of 3.9 percent in September, could fall to 1.3 percent by October 2012, according to a measure of expectations calculated by the Federal Reserve Bank of Cleveland.

That would leave the rate below the U.S. central bank’s 1.7 percent to 2 percent comfort zone.

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