By Alison Rice. Usually it's inflation--rising prices--that worries the Federal Reserve Board. Not right now. After its May meeting on monetary policy and interest rates, the Fed alluded to the economy's ongoing weakness and "the probability of an unwelcome, substantial fall in inflation" or deflation.
"Deflation is a concern because if it does occur, it will be devastating," explains Celia Chen, director of housing economics at Economy.com in West Chester, Pa. "It's low-probability, but high-risk."
Deflation is what happens when overall prices for goods and services decline, which can depress worker wages, business profits, asset values, and the overall economy. "If prices for goods and services start to fall, people may decide not to buy," say David Seiders, chief economist at NAHB. "If they were looking at borrowing money, they don't want to borrow," because whatever they purchase with their loan money will end up being worth less than they paid.
Businesses suffer, too, as they cut prices to generate demand. This squeezes margins, limiting the ability to grow, and could even result in cost-cutting measures such as layoffs. It's a difficult economic scenario, and one that could threaten the feeble U.S. economy with a double-dip recession and potentially undermine the housing market.
That said, deflation currently remains just that: a threat, not a reality. "I don't think there's too much risk of a general price deflation in the U.S. economy," says Frank Nothaft, chief economist for Freddie Mac. "You'd have to go back to the 1930s to see that."
And, he says, there's enough happening, from government spending to potential tax cuts, to spur the economic growth necessary to head off deflation.
The Fed's concern and apparent willingness to cut rates could prove helpful to builders for the near future. "It's great news for housing, because it means a continuation of a low interest rate environment," says Nothaft. With the federal funds rate at 1.25 percent, mortgage rates on May 15 hit the lowest levels since 1958. Interest rates stood at 5.45 percent on a 30-year fixed loan and 3.67 percent for a 1-year ARM, according to Freddie Mac's weekly survey.
But it's not a place builders necessarily want to stay. "We need to get out of the deflation danger zone," Seiders says. "We don't want to risk being involved in that deflationary mess."