Some commentators predict US may be entering a long period ofdeflation

During September, conditions in equity markets across the globe have continued to test the nerves of even the steeliest of investors. This bear market is now unquestionably the worst since 1973/74 and there is a palpable sense within the investment community that the worst is yet to come.

The recent further slide in equities seems to be associated with a significant shift in expectations for the US economy. Up to recently, the consensus view was that it would continue to recover into 2003. More recent information, particularly regarding the strength of consumer confidence, has led to a reassessment of this viewpoint.

Personal consumption has been the key factor explaining the resilience of the US economy in recent years. Despite the weakness in share prices and the deterioration in employment prospects, the US consumer has continued to spend.

However, there are signs that chinks are beginning to appear in the American consumers' willingness to spend. Even modest weakness in consumer spending would have a major impact on overall GDP growth, particularly in view of the weakness in investment spending by the corporate sector.

This somewhat more negative assessment of the American economy has led investment analysts to downgrade their expectations regarding corporate profits. Such downgrades undoubtedly provide at least a partial explanation for the recent weakness in share prices.

Possibly of greater significance is that the weakening in consumer sentiment is being interpreted by some commentators as an indication that the American economy may be entering a prolonged period of deflation. The fear is that America could experience something akin to the Japanese deflation of the past 10 years.

During the late 1980s, Japan experienced a stock market bubble and a property market bubble. Share prices peaked in the early 1990s and have since fallen to average values today that are less than one-third of peak values.

Deflation is usually associated with declines in the broad measures of inflation such as consumer price indices. However, declining prices can also occur in periods of growth. The defining aspect of a deflationary period is that demand for goods and services is well below the production capacity of the economy. Japan has been exhibiting symptoms of classic deflation for several years.

Falling prices throughout the system discourage spending, which means that firms have no reason to invest. It is a process that feeds on itself as declining prices encourage consumers to defer spending even further.

In a deflationary environment, nominal interest rates effectively decline to zero. This is now the case in Japan with three-month interest rates quoted at 0.1 per cent.

American interest rates have declined dramatically since the start of the millennium. At end- 1999, three-month interest rates in the US stood at 5.2 per cent compared with the current level of 1.6 per cent. This is a fall of over 3.5 percentage points, bringing dollar interest rates to 40-year lows.

The experience in the US stands in sharp contrast to that of the euro zone, where interest rates today of 3.3 per cent are at the same level as at end-1999. The British economy has followed the US pattern except that sterling interest rates have only fallen from 6.0 per cent to just under 4 per cent.

Short-term interest rates tend to be more volatile than long-term bond yields and hence analysts rely on movements in bond yields to provide clues regarding overall economic trends. At end-1999 euro-zone and British 10-year bond yields were exactly the same at 5.5 per cent and both yields have since fallen by 1 per cent.

Reflecting the booming state of the American economy at end-1999, dollar 10-year yields were significantly higher and yielded 6.4 per cent at that time. However, US bond yields have since fallen very sharply and now trade at 3.8 per cent, which is materially lower than euro bond yields.

The fact that investors are prepared to purchase bonds at such low yields indicates that fears regarding deflation in the US economy are very real. Because of the perceived weak state of the US economy further declines in US short-term interest rates are now firmly back on the agenda. If the Federal Reserve cuts rates before year-end it is likely that the European Central Bank will do likewise.

Further cuts from current very low levels will be the clearest indication yet that central banks are now more concerned about deflation rather than inflation.

After two decades of tackling inflation this would indeed represent the crossing of the Rubicon by the developed economies' conservative central bankers.