Sewell Chan at NYT:
A subtle but significant shift appears to be occurring within the Federal Reserve over the course of monetary policy as the economic recovery is weakening.
On Thursday, James Bullard, president of the Federal Reserve Bank of St. Louis, warned that the Fed’s policies were putting the economy at risk of becoming “enmeshed in a Japanese-style deflationary outcome within the next several years.”
The warning by Mr. Bullard, who is a voting member of the Fed committee that determines interest rates, came days after Ben S. Bernanke, the Fed chairman, said the central bank was prepared to do more to stimulate the economy if needed, though it had no immediate plans to do so. On Friday, the government will release its estimate of gross domestic product for the second quarter of this year.
At the Fed, Mr. Bullard had been associated with the camp that sees inflation, the central bank’s traditional enemy, as a greater threat than deflation brought on by anemic growth. Until now he had not been an advocate for large-scale asset purchases to reinvigorate the economy.
But with inflation very low, about half of the Fed’s implicit target of 2 percent, and with the European debt crisis having roiled the markets, even self-described inflation hawks like Mr. Bullard have gotten worried about the economy’s trajectory.
With his remarks on Thursday, Mr. Bullard appeared to join other Fed officials already seen as sympathetic to the view that damage from long-term unemployment and the threat of deflation are the greatest challenges facing the economy. They include the Fed bank presidents Eric S. Rosengren of Boston and William C. Dudley of New York.
Those so-called inflation doves are likely to be joined soon by three new members of the Fed’s board of governors.
That view is not universally held, however.
Thomas M. Hoenig, president of the Kansas City Fed and an inflation hawk, said in an interview Thursday that the comparisons to Japan were overstated. He likened the debate to the situation in mid-2003, when a sluggish recovery from the 2001 recession prompted predictions of deflation that did not come to pass. “I don’t think we should find ourselves picking up every piece of short-term data and jumping to conclusions,” he said.
Two others associated with the hawkish camp, which is focused on continued vigilance on inflation, offered similar perspectives in separate interviews.
“I think the fear of deflation in and of itself is probably overblown,” Charles I. Plosser, president of the Philadelphia Fed, said last week. He said that inflation expectations were “well anchored” and noted that $1 trillion in bank reserves was sitting at the Fed. “It’s hard to imagine with that much money sitting around, you would have a prolonged period of deflation,” he said.
Neil Irwin at WaPo:
Here is the executive summary of Bullard’s paper, and the full document, with the ominous title “Seven Faces of ‘The Peril.’ ” His two main conclusions: that the Fed’s commitment to leave rates low for an extended period “may be increasing the probability of a Japanese-style outcome for the U.S.,” and that “on balance, the U.S. quantitative easing program offers the best tool to avoid such an outcome.”
Bullard’s paper comes at a crucial time, as the Fed starts to weigh whether the risk of deflation and extended weak growth is high enough to warrant new action. Chairman Ben S. Bernanke indicated openness to new policy steps to boost growth in congressional testimony last week, but made clear that they would only be undertaken if conditions worsen further.
Bullard’s analysis adds to that debate in some interesting ways. Bernanke suggested that the Fed could promise to leave its short-term interest rates low for even longer than the “extended period” it has already. Bullard is calling that strategy potentially counterproductive.
His argument: Essentially that the pledge of low rates signals that Fed leaders expect inflation to keep falling, making it more likely that the economy settles into the deflation trap in which the Japanese economy is stuck.
It’s particularly interesting to see Bullard raise the specter of deflation, because he is generally viewed as residing on the other side of Fed policy debates, on the inflation hawk side of things.
Colin Barr at Fortune:
The support for another round of asset purchases is noteworthy because Bullard has been both a supporter of Fed asset purchases and a worrier about the potential inflationary impacts. His support for more asset purchases suggests he believes the balance has swung against inflation.
Japan has endured two decades of economic stagnation after its asset price bubbles burst around 1990. It has been widely assumed this country could avoid such an outcome, but that assumption has come under fierce attack lately, with a weakening growth outlook and a sharp decline in Treasury bond yields.
The 10-year Treasury yield has dropped to around 3% from 4% this spring, and some growth skeptics now say it could tumble another percentage point or more. This decline happened even as the Fed this spring signaled it would hold rates near zero further into the future, as a response to the unrest in European debt markets.
This response appears to be “inflationary,” Bullard writes, by delaying the Fed’s exit from its two-year-old detour into the world of free money. Yet the market’s inflation expectations tumbled.
“Promising to remain at zero for a long time is a double-edged sword,” he concludes.
Bullard is the second top Fed official to part with Fed chief Ben Bernanke on the “extended period” language. Kansas City Fed chief Thomas Hoenig has called on the Fed to drop that promise and modestly raise interest rates.
My econ is a bit rusty and I was never much of a macro guy, but is there any way in which this reasoning makes any sense at all?
“I think the fear of deflation in and of itself is probably overblown, from my perspective,” Charles I. Plosser, president of the Philadelphia Fed, said last week in an interview. He said that inflation expectations were “well anchored” and noted that $1 trillion in bank reserves was sitting at the Fed. “It’s hard to imagine with that much money sitting around, you would have a prolonged period of deflation,” he said.
Atrios asks whether this makes sense. No, it doesn’t. I mean, if we’re talking about the risk of turning Japanese, shouldn’t we, um, look at Japanese experience? Here’s Japan’s monetary base — the sum of bank reserves and currency in circulation — from 1995 to 2005:Bank of Japan
All that money sitting there — and deflation continued apace. I remember Taka Ito telling me that the only consumer durable selling well was … safes. When you’re in a liquidity trap, the size of the base doesn’t matter.
But at least some Fed types are getting it.
Ryan Avent at Free Exchange at The Economist:
On the other hand, the only one of the sceptics listed above that’s currently a voting member of the FOMC is Mr Hoenig. The number of vocal deflation worriers is quite close to a majority. So perhaps more action will be forthcoming soon.
My colleague also noted, however:
I think Mr Bernanke himself, however, is ambivalent on the benefit of more QE. He’s not sure of the unintended consequences of printing all that money. And the next round of QE will have less impact than the first because the spread between mortgage rates and Treasury yields has collapsed since the first round of QE. So the benefits of more QE are smaller and the costs greater than they were a year ago.
So how about it? This may be true. At the same time, the risk of deflation is greater than it seemed a year ago. Below is the Cleveland Fed’s trimmed mean measure of consumer price inflation. Year-over-year, prices are up under 1%, and the trend line is clearly downward.
My colleague argues that the two powerful tools left to the Fed—explicit devaluation and a money-financed fiscal stimulus (a helicopter drop)—would take Treasury approval and are unlikely to be pursued.
Wouldn’t it be awesome if the Fed and other government agencies took advantage of domestic Nobel Prize winning economists? For christ sake- someone google “Krugman+lost+decade” and tell me how many hits you come up with. He’s done just about everything except tattoo it on his chest and back and then do a pay-per-view boxing match with Tonya Harding.
UPDATE: James Ledbetter at Slate