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Fed Should Resume Treasury Purchases If Deflation Risk Grows, Bullard Say
Federal Reserve Bank of St. Louis President James Bullard said the central bank should resume purchases of Treasury securities if the economy slows and prices fall rather than maintain a pledge to keep rates near zero.
“The U.S. is closer to a Japanese-style outcome today than at any time in recent history,” Bullard said, warning in a research paper released yesterday about the possibility of deflation. “A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”
Bullard’s stance increases the odds the Fed will make such a move and reject other options should the economy weaken further, former Fed Governor Lyle Gramley said. Other alternatives to aid growth include using communication to plot the path of interest rates or cutting payments to banks on reserve deposits, Chairman Ben S. Bernanke said last week.
“It’s going to be very important in shifting the mix of thinking at the Fed,” said Gramley, now senior economic adviser with Potomac Research Group in Washington. “Having Jim Bullard on the side of doing that could, I think, be the straw that broke the camel’s back.”
The Fed signaled last month that Europe’s debt crisis may harm U.S. growth and repeated a pledge to keep interest rates near zero “for an extended period.” The central bank cut the benchmark interest rate almost to zero in December 2008 and turned to purchases of Treasury, housing-agency and mortgage- backed securities as the main tool for monetary policy.
‘All Go Away’
“The most likely possibility from where we sit today is that the recovery will continue through the fall, inflation will start to move up and this issue will all go away,” Bullard said to reporters on a conference call yesterday. “Suppose we get another negative shock, another surprise. We have to be prepared in that event to have a plan in place to do something.”
Bullard, a voting member of the Federal Open Market Committee this year, said using Fed communications to pledge rates will stay near zero may prove to be detrimental. While some people say rates near zero will accelerate inflation, such an interest rate policy may also cause a broad-based decline in prices, he said.
Bullard, who describes himself as “the north pole of inflation hawks,” has taken a broader stand on policy since he assumed leadership at the St. Louis Fed in April 2008 amid the deepest U.S. recession since the 1930s.
In November, Bullard said past experience suggests the Fed may not start to raise interest rates until 2012. That same month, he said the Fed should retain the flexibility to respond to any weakening in the economy by extending beyond March its authority to buy mortgage-backed securities and agency bonds.
“They have to be talking about all these options,” said former Atlanta Fed research director Robert Eisenbeis, now chief monetary economist at Cumberland Advisors Inc. At the same time, “I don’t see much happening” in the statement after the next FOMC meeting Aug. 10, Eisenbeis said.
Bullard said he wrote the paper after private-sector economists reacted to the European debt crisis by assuming the Fed would extend its extended-period rate pledge further, raising a risk of deflation. An additional shock, such as a terrorist attack or weakness in Asia, would require a different policy, he said.
“The academics will tell you what you have to do is sort of dump interest-rate targeting and switch to something else,” he said. “In the policy debate, that is not really happening. So we need a sharper departure from interest-rate targeting if we are going to get out of this problem.”
Bullard, who has voiced concerns with the extended-period language since early March, said during the call he wanted to spark debate and his preference has been not to dissent.
Fed officials held mixed views on deflation last month, with “a few participants” citing “some risk of deflation,” according to the minutes of the June meeting. “Other participants, however, thought that inflation was unlikely to fall appreciably.”
Charles Plosser, president of the Philadelphia Fed, said in an interview this week that “I don’t think deflation, or sustained deflation, is a real problem at this point. It is hard to imagine how you can get that when you have got a trillion dollars in excess reserves sitting in the banking system or as long as expectations of inflation are well anchored.”
Separately yesterday, Dallas Fed President Richard Fisher told reporters that “we’re still seeing slightly increasing prices.” Fisher, in San Antonio, said he doesn’t “see any deflationary net pressure.”
Boston Fed President Eric Rosengren, in an interview with the New York Times published yesterday, said that while he wasn’t forecasting deflation, “it’s a risk that I do take seriously, and we should continue to monitor what’s happening with prices.” Deflation is a “greater risk” than inflation, Peter Diamond, nominated to be a Fed governor, said this month in a written response to questions from Senator Richard Shelby.
Bullard’s stance aims to bridge the gap between two camps at the Fed, said Vincent Reinhart, a former Fed monetary-affairs director. Bernanke is in one group believing that the path of short-term rates is important, while Kansas City Fed President Thomas Hoenig is among officials uncomfortable with the “extended period pledge,” Reinhart said.
‘More in Play’
“It raises the sense that the balance sheet is more in play,” said Reinhart, a resident scholar at the American Enterprise Institute in Washington.
Bullard said deflation could hurt the U.S. financial system because falling prices undermine the value of financial contracts such as mortgages. His comments echoed Bernanke’s research on the Great Depression indicating that declines in borrowers’ net worth can worsen a downturn.
“The conventional wisdom is that Japan has suffered through a ‘lost decade’ partially attributable to the fact that the economy has been stuck in the deflationary, low nominal interest-rate-steady state,” he said. “To the extent that is true, the U.S. and Europe can hardly afford to join Japan in the quagmire.”
The St. Louis Fed president, who said he visited Japan a month and a half ago, said policy makers there had been unsuccessful with efforts including “aggressive fiscal expansion.”
“They have tried many, many things to change their situation and they haven’t worked very well,” he said.
Bullard said during the call that U.S. inflation expectations are “holding up,” while having “fallen quite a bit.”
The Fed in March ended its emergency purchases of $1.425 trillion of housing debt after completing purchases of $300 billion in Treasury securities in October.
Bullard said the program was generally regarded as successful in the U.S., along with a similar policy in the U.K.
“The global economy continues to recover from the very sharp recession of 2008 and 2009,” Bullard said. “During the recovery, the U.S. economy is susceptible to negative shocks which may dampen inflation expectations.”
Employment fell in June for the first time this year because of a drop in the number of U.S. census workers, while private payrolls rose 83,000, the Labor Department said. Reports over the past month showed a decline in home sales, a slump in consumer confidence, weaker manufacturing and less growth in the first quarter.