This post is a guest contribution by Asha Bangalore, vice president and economist of The Northern Trust  Company.

Chairman Bernanke is scheduled for the semi-annual testimony about the economy at the Senate Banking Committee on Wednesday, July 21. The U.S. economy is in the throes of an economic recovery but the risk of deflation has entered the picture. The deflationary threat seemed to have been defeated the last time he presented an update of the economy to Congress. On a year-to-year basis, the Consumer Price Index (CPI) and the personal consumption expenditure price index, the Fed’s preferred measure are both holding above zero (see Charts 1 and 2). However, on a month-to-month basis, the CPI posted the third monthly drop. The personal consumption expenditure price index declined in May and the estimates for June will be published on August 3.

In 2002, Chairman Bernanke delivered a speech about deflation (Deflation: Making Sure “It” Doesn’t Happen Here ) where in he noted “when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates“. Bernanke could use the upcoming testimony as an opportunity to present more details about this issue. The Fed has the option to lower the interest rate paid on excess reserves to induce banks to lend or renew some of the expired special programs to purchase private sector debt. An elaboration of the Fed’s options is possibility at this testimony.

Speaking about bank lending, the broken credit machine is the challenge of the year. Bank lending has declined for six straight quarters (see Chart 3). The financial accommodation from the Fed is parked as excess reserves of the banking system and is not being converted to loans. The Chairman’s thoughts about the severe credit contraction should be most important topic of the testimony in addition to deflation.

Source: Asha Bangalore, Northern Trust Daily Global Commentary, July 19, 2010.

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