Fed's Bullard: Economy Facing Risk Of Sustained Deflation

JamesBullard 021709

The U.S. economy is facing a risk of sustained deflation, a top fed official warned Tuesday. Speaking before the New York Association for Business Economics Harvard Club of New York in New York, St. Louis Federal Reserve President James Bullard urged the Federal Reserve to focus on quantitative policy actions and expanding the monetary base to fight the real threat of deflation.

Bullard noted that it is "reasonable to say that core inflation is running at zero to slightly negative rates at this time," or that there is a possibility that the economy is currently muddling through a deflationary period.

Moreover, he added that with the recession expected to continue "at least" through the first half of 2009, there is risk that the deflation could continue "for some time to come.

"Should lingering financial turmoil continue to weigh on the economy and stretch the recession out still longer, the zero or negative inflation could continue through 2009," Bullard said in prepared remarks.

Expanding his warning, the St. Louis Fed President cautioned that "over that time frame, deflationary expectations could become entrenched."

"For this reason I think we face some risk—at this point only a risk—of sustained deflation," Bullard added.

He urged policymakers to take steps to guide the economy away from the deflationary outcome, warning that failure to prevent ongoing deflation could be "particularly pernicious," warning that the already crumbling housing market could see further deterioration.

"With sustained deflation, the foreclosure experience that we have seen in the subprime market could generalize to a wider spectrum of homeownership," he warned, an outcome that would likely prolong the recession.

However, while in normal circumstances the Federal Reserve would simply lower the federal funds rate to fight deflation, the rate is already at a record low target range between 0 and 0.25 percent, and are expected to remain that low for some time.

"Expectations of deflation for the next five years may feed into real interest rates, driving real rates higher just at the time monetary policy would like to move them lower," Bullard warned. "The zero bound is constraining ordinary policy responses to this situation, making things worse."

"I believe it is fair to conclude that we are entering an extended period of exceptionally low policy rates globally," Bullard predicted. "In the United States, the setting of nominal interest rate targets as a monetary policy tool will be off the table for some time."

Therefore, in order to stave off a deflationary period there should be a focus on quantitative measures of policy, the St. Louis Fed President urged. Although the extreme approach would not be recommended in normal circumstances, the extraordinary state of the economy requires extraordinary action, Bullard said.

"To avoid the risk of deflation, it is important that the Fed provide a credible nominal anchor for the economy," he explained. "One way to do so is to set quantitative targets for monetary policy, beginning with the growth rate of the monetary base."

He urged the Federal Reserve to expand the monetary base at an "appropriate rate," allowing the Fed to signal that it "intends to avoid the risk of further deflation and the possibility of a deflation trap."

In addition, Bullard addressed the "astonishing" amount of liquidity injected into financial markets by the Federal Reserve since September 2008, expanding the size of its balance sheet from $900 trillion at that time to $2.2 trillion in December 2008.

"The outright purchases of agency debt and MBS are likely to be more persistent…and it is these purchases that may provide enough expansion in the monetary base to offset the risk of further disinflation and possible deflation," Bullard noted. "The quantitative effects of policy actions in this new environment are more uncertain than normal, but nevertheless these less-conventional policies can have every bit as powerful an impact on the economy as changes in the intended federal funds rate."

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