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 today 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.”
Fed policy makers are considering what actions to take, if any, to spur growth and reduce unemployment should the economy weaken further. Chairman Ben S. Bernanke told Congress last week the Fed could use communication to plot the path of interest rates, cut the rate it pays banks on excess reserves or purchase more bonds.
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.
“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 today. “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.”
Rate Pledge
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.
“Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome,” he said in a paper released by the St. Louis Fed.
Bullard, who has voiced concerns with the extended-period language since early March, said on 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.”
Not ‘Real Problem’
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.”
Peter Diamond, nominated to be a Fed governor, said this month in a written response to questions from Senator Richard Shelby, that deflation is a “greater risk” than inflation.
“While I do not think that significant deflation is a likely outcome, the risk from inflation rising beyond the desired range in the near future appears even smaller,” Diamond said to Shelby of Alabama, the senior Republican on the Senate Banking Committee.
Falling Prices
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.”
Bullard said on 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, cooler manufacturing and less growth in the first quarter.