Inflation causes prices to rise because the Federal Reserve creates more money than the economy needs. Conversely deflation results in falling prices because the central bank creates a shortage of money.
So, if the most important goal of monetary policy is domestic price stability -- i.e., neither the risk of inflation nor deflation -- then the Federal Reserve should provide additional liquidity for the economy.
While some reflation is occurring today, it's not entirely certain that deflation has completely passed us by. Business prices are now rising at about 1 percent. This is not much of a comfort zone since the way government measures prices -- in particular, the prices of services -- is imperfect at best.
Durable goods prices, however, have been falling steadily by nearly 3 percent. This is exactly what Alan Greenspan and the Federal Reserve should be concerned about. The price category known as "furniture and household equipment" (think appliances) is deflating at about a 5 percent rate. The "other durable goods" category is deflating by about 1 percent. Motor vehicles and parts are falling by slightly more than 1 percent.
Other more widely followed price indexes, such as those for personal spending, producer prices, and consumer prices, are rising by about 1 percent to 1.5 percent on balance. But again, that's pretty close to the edge of deflation when measurement uncertainties are taken into account.
Treasury yields provide more evidence that we're not yet out of the deflationary woods. If deflation expectations have truly been eliminated, and growth expectations have taken over, then the difference -- or the "fed spread" -- between the interest rate attached to the 2-year Treasury note and the federal funds interest rate would be much wider today.
And if growth expectations and pricing power have recovered sufficiently, then Treasury rates across the maturity spectrum would be rising noticeably. But that has not yet happened.
During the investment boom of the second half of the '90s, interest on the 10-year Treasury note averaged 6 percent, in step with growth of real gross domestic product. So, today's unusually low 4 percent yield for the bellwether Treasury should revert back to a higher rate that is characteristic of stronger economic performance.