By David F. Seiders. The Federal Reserve is deeply concerned about the possibility of price deflation in the U.S. economy, a phenomenon that has helped keep the Japanese economy in the tank for more than a decade.

While deflation may be a legitimate concern in broad economic terms, a deflationary process would not necessarily engulf the housing industry. The Fed's expression of concern actually has supported house values so far, and interest rate adjustments should be able to prevent development of a broad-scale deflationary spiral over the long term.

Deflation concerns

On May 6, the Federal Reserve proclaimed the threat of price deflation had become a major issue for the U.S. economy. This was a historic turnabout for a central bank that has persistently extolled the economic benefits of stable prices (zero inflation). In essence, the Fed concluded that inflation had been reduced to the point where outright deflation (falling prices) had become a real possibility. Our central bank obviously does not want to join the Bank of Japan in its desperate efforts to stem a destructive deflationary tide.

If price stability is supposed to be good for the economy, why is deflation viewed as an unmitigated evil? Experience shows that mild deflation can quickly spiral into serious deflation. In that environment, consumers and businesses hold back on spending because prices are falling, they are hesitant to borrow because they will have to pay back more purchasing power than they get, and the central bank can't reduce interest rates by enough to fight off reluctance to borrow and spend. That's exactly what happened in Japan, where short-term rates have been set at zero for years and policymakers have been unable to revive the economy.

House prices

Deflation means falling prices for goods and services in the economy but does not necessarily involve falling prices for tangible assets such as houses. House prices do not enter any of the inflation measures that the Federal Reserve is concerned about, and there's been a major divergence between the performance of house prices and those broad inflation measures. House prices have continued to rise at a solid pace while general inflation has gravitated toward zero, generating dramatic increases in real (inflation-adjusted) house values.

A persistent deflationary spiral could ultimately engulf house prices, of course, through erosion of household income as well as the cost of producing homes, but a fall in real house values still would not be inevitable. That's because falling interest rates would be part of the process, supporting housing affordability as well as property valuations grounded on the discounted value of future housing services.

Interest rate support

The Fed's public expression of deflation concerns put immediate downward pressure on long-term interest rates even though the Fed did not drop short-term rates. In effect, the Fed talked long rates down while conserving ammunition at the short end of the rate structure. The effect was to support home buying and put firm support under house prices.

Looking ahead, aggressive monetary policy support should be able to fend off the incipient deflationary threat and keep the single-family housing market in great shape. Indeed, Fed Chairman Greenspan has assured Congress that the central bank is prepared to roll out unconventional weapons if necessary, and the implications for housing would be very positive. Greenspan is talking about frontal attacks on long-term Treasury rates, and declines in those rates would reduce long-term mortgage rates in tandem.