Beware the Monetary Cliff

Unlike the U.S. fiscal cliff, which was largely defused by congressional action, the U.S. monetary cliff — which will be reached if U.S. inflation rates turn negative — cannot be easily circumvented. Because the United States is the largest economy in the world, U.S. deflation would be exported to the rest of the world, says John H. Makin, a resident scholar at the American Enterprise Institute.

The Fed, under Chairman Bernanke and soon-to-be chairman Yellen, can do three things to reduce the risk of going over the deflationary monetary cliff.

First, the Fed should temper its complacency about the possibility of further disinflation and deflation.

Second, the Fed could underscore its desire to avoid deflation by setting a new target range for inflation with a firmly defined lower bound.

Third, Janet Yellen’s elevation to the chairmanship of the Fed presents an opportunity to underscore its commitment to avoid deflation. By discussing the risk of deflation at some length and by putting a firm floor on the Fed’s willingness to tolerate a drift toward deflation, Yellen could substantially reduce the risks that fears of deflation could produce.

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