Deflation concerns gain new advocate
Paper by chief of St. Louis Fed warns of ‘Japan-style outcome’ if key rate isn’t increased soon
In an unusual move that underscored an intensifying debate at the Federal Reserve, the president of the St. Louis Fed released a paper Thursday warning that the central bank’s policy of keeping interest rates near zero during the economic crisis could lead to deflation as severe as that facing Japan.
In deflation, asset prices fall, and a downward spiral takes hold, where businesses and consumers hoard cash on the assumption that prices will be lower soon. That leads to a stall in economic growth, or contraction, and jobs and income are lost in a downward spiral. Japan has long been mired in such a slump; America’s last serious case of deflation was during the Great Depression in the 1930s.
The president of the St. Louis Fed, James Bullard, warned that without more aggressive moves to spark its own slowing economy, the U.S. could be in for similar debilitating deflation. The Fed has kept its benchmark interest rate at a record low between zero and 0.25 percent since December 2008.
“Promising to remain at zero for a long time is a double-edged sword,” he warned, saying
that the Fed’s effort to stimulate the economy that way may have the unintended consequence of anchoring expectations for falling prices. “The U.S. is closer to a Japanese-style outcome today than at any time in recent history.”
For now, Bullard thinks the deflation risk is still low, but his paper amplifies concerns about the possibility — as well as the unease inside the central bank over taking new steps to stimulate growth. Kansas City Fed President Thomas Hoenig has consistently voiced his concerns about deflation at the Fed board’s monthly meetings this year.
Fed Chairman Ben Bernanke and his colleagues are due to meet next on Aug. 10. Economists don’t think the Fed will announce new policy actions at that time unless the economy seriously deteriorates before then.
Bernanke told lawmakers on Capitol Hill last week that the Fed policymakers had several options if the economy worsens. They could cut to zero the interest rate paid to banks on money parked at the Fed. They could also provide more information about how long it will keep interest rates at record lows. Bernanke also left the door open to restarting programs to buy mortgage securities or government debt, the latter which Bullard says should be considered.
A better way to stimulate economic growth now, Bullard argued, is to have the Fed aggressively buy up government debt. The Fed tried this at the start of the crisis, with some success. During a period of late 2008 and early 2009, the Fed purchased securities backed by U.S. mortgages, auto loans and other debt, including up to $300 billion in U.S. Treasury securities. The result was lower interest rates for businesses and consumers, especially homeowners, and greater economic activity.
The Fed’s balance sheet also swelled to an unprecedented $2.3 trillion, raising concerns about how the Fed could pay off those debts and that it might end up monetizing the debt and effectively devaluing the currency.
“It pays to think ahead about things that might happen,” Bullard told reporters. “This is a matter of being ready, in case something else hits.”