A top U.S. Federal Reserve official warned Thursday the U.S. economy is close to sliding toward Japanese-style deflation, and the current policy of keeping interest rates at near-zero for an extended period might exacerbate matters.
James Bullard, president of the Federal Reserve Bank of St. Louis, said in a policy paper the best way to avoid such a dangerous outcome is for the U.S. central bank, despite its already bloated balance sheet, to buy up U.S. Treasury bonds.
“The U.S. is closer to a Japanese-style outcome today than at any time in recent history,” Mr. Bullard said.
The promise to keep the key policy interest at near-zero for an extended period, as the U.S. Federal Reserve has been wont to do, is a “double-edged sword,” he said, because it could reinforce expectations that inflation will fall further.
“A better policy response to a negative shock,” he said, “is to expand the quantitative easing program through the purchase of Treasury securities.”
Analysts say Mr. Bullard’s comments mark a sea change as up until now Fed officials in Washington, from chairman Ben Bernanke onward, have largely avoided talking about deflation and Japan, instead referring to downside risks to the economy.
“This is the first time I have seen a regional Fed bank president discuss deflationary risks to this extent, and to come right out with a comparison to the Japanese experience. This is truly remarkable,” said David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates. “This is not an exercise in mincing words.”
Eric Green, New York-based chief U.S. strategist with TD Securities, said Mr. Bullard’s message reinforces a view that the Fed is closer to providing further stimulus to the economy. This is something Mr. Bernanke said last week was an option should it be required, although suggesting the Fed hadn’t given it much thought.
“The Fed had thought more about tightening than it has about more easing. That is beginning to change,” Mr. Green said. “The Fed has a right to be concerned about how things are developing.”
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Economic data from the United States have come in weaker-than-expected, showing a decline in home sales, a slump in consumer confidence, and weaker manufacturing. Further, job growth has not taken off as expected — payrolls shrank in June. The fear is the U.S. economy could face another downturn, and the federal government would have little room to spend more on infrastructure or cut taxes, as voters are already worried about the country’s sky-high debt levels.
This raises the spectre of deflation, or falling prices, much like Japan. Consumer prices in the United States have been falling, with core inflation, which excludes volatile-priced items, recently hitting its lowest level since 1966.
Japan has struggled to deal with deflation for the better part of two decades, sparked after that country sustained a collapse in its real estate and financial markets in the early 1990s. Deflationary pressure built up and Japan’s policy makers were slow to react — and when they did, Mr. Bullard said, they were ineffective.
Speaking to reporters following the release of his paper, Mr. Bullard said he was hoping to spark debate.
“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 go away,” he said. “[But] 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.”
He said the purchase of securities by the U.S. and Bank of England at the onset of the most recent financial crisis succeeded in terms of bringing down longer-term borrowing costs because markets believed the two central banks would do “whatever it takes to avoid particularly unpleasant outcomes for the economy.”
By Paul Vieira – Financial Post
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