Lesson 5
The Deflation Risk
Never underestimate how hard the Fed will fight deflation. If deflation risk appears (credit collapsing, prices falling), expect MASSIVE intervention. Deflation risk = Fed panic = asset reflation.
Everyone fears inflation, but the Fed's REAL nightmare is deflation. Understanding why reveals the Fed's true priorities.
What Deflation Is: Falling prices across the economy. Sounds good, right?
Why Deflation Is Worse Than Inflation:
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Debt Becomes Heavier: If prices fall 5% but your mortgage stays the same, your debt is effectively 5% larger in real terms.
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Spending Delays: If you expect prices to be lower tomorrow, why buy today? This is a deflationary spiral.
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Wages Are Sticky Downward: Companies cut jobs instead of wages. Unemployment spikes.
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Monetary Policy Becomes Impotent: You can't cut rates below zero effectively. The Fed loses its main tool.
The Fed's True Mandate:
Officially: 2% inflation target.
In practice: AVOID DEFLATION at all costs. The Fed will tolerate 4% inflation much longer than 0% inflation. Deflation is existential; high inflation is painful but survivable.
This Explains Fed Behavior:
Why does the Fed ease aggressively in crises but tighten slowly in recoveries? Because the downside (deflation) is catastrophic, while the upside (inflation) is manageable. The asymmetry drives the asymmetric response.
Check your understanding
Lesson Quiz
Quiz Check
Why does the Fed fear deflation more than inflation?