WASHINGTON — In an unusual move, the president of the Federal Reserve Bank of St. Louis released a paper Thursday warning that the Fed's policy of keeping interest rates near zero during the economic crisis may lead to Japanese-like deflation in coming years.
Japan has been mired in a long economic slump with low growth and falling prices, or deflation. The St. Louis Fed President James Bullard warned that absent more aggressive moves to spark its own slowing economy, the U.S. could be in for similar debilitating deflation. The Fed targets its benchmark interest rate at between zero and a quarter percentage point.
"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.
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 vicious spiral down.
Bullard's paper was notable in part because he's viewed as an "inflation hawk," someone who believes that the Fed should err on the side of higher interest rates to prevent any excessive rise in prices across the economy.
His paper Thursday amplifies concerns about the possibility of deflation, or a progressive fall in prices across the economy, raised earlier by Kansas City Fed President Thomas Hoenig. Earlier in the month, Nobel Prize winning economist Paul Krugman warned that the economy was "visibly sliding toward deflation — and the Fed is standing pat."
Testifying before Congress last week, Fed Chairman Ben Bernanke acknowledged that the deflation threat, last seen in the U.S. in 2003, is on his radar screen. A broad range of responses are under consideration, he said, adding that he didn't feel the time was right yet to act.
Those who fear deflation point to the trend in core U.S. inflation, a measure that strips out volatile food and energy prices. Through June, core inflation was running at a year-over-year rate of 0.9 percent, the lowest since 1966, and below the Fed's target rate of 1 percent to 2 percent annually.
"The U.S. is closer to a Japanese-style outcome today than at any time in recent history," Bullard wrote in his paper entitled Seven Faces of "The Peril." The title references an academic paper on the perils in monetary policy.
Bullard argues that by holding its benchmark lending rate near zero for more than 18 months, and by promising to do so for the indefinite future, the Fed has wet gunpowder. The effort may have failed to stimulate the economy sufficiently to power it forward, and public expectations for inflation may fall. Unanchored expectations could become a self-fulfilling prophecy of downward prices.
A better way to stimulate economic growth now, Bullard argued, is to have the Fed aggressively buy up government debt. Economists call this process quantitative easing; it has the effect of printing more money because it increases the supply of money in the economy. That stimulates both inflation and expectations of future inflation.
By purchasing government debt, the Fed also would seek to drive down the return to investors, called the yield, forcing them to take risks in the economy in search of a higher return, promoting growth in the process.
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 and car loans, and other forms of debt, including U.S. Treasuries. The result was lower interest rates for companies and consumers, especially homeowners, and economic activity.
However, the Fed's balance sheet also swelled to an unprecedented $2.3 trillion, raising fears of how the Fed could pay off those debts, and worries that it might end up monetizing the debt and effectively devaluing the currency.
"I've never been through anything quite like this in my life, and I don't think the economy has," said Lyle Gramley, a Fed governor from 1980 to 1985.
Gramley, an octogenarian, holds a long view on the economy: He was a boy during the Great Depression.
He said the Fed's options to spur the economy now include stopping payment of interest to banks on deposits at the Fed and lowering the Fed's benchmark lending rate officially all the way to zero to encourage lending.
"How much good those things would do, I don't think anyone knows. But they would be more symbolic than anything else," he said.
Bullard recommends buying Treasuries, but doesn't say whether he favors shorter-term debt such as those that mature in two years, or longer-term debt that matures in 10 years.
Gramley thinks any such effort will fail unless focused on the 10-year bonds.
"If they are willing to go out and buy long-term Treasuries, that would make a difference," he said.
Underscoring how unusual that would be, Gramley said the last time the U.S. government did this was during World War II, to reduce the cost of borrowing in a time where wage and price controls also were imposed on the economy.
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