Fed Headed for Deflation Trap

The Federal Reserve’s promise to keep its target interest rate near zero for an “extended period” could have the counterproductive effect of encouraging a Japan-like deflation trap, according to Federal Reserve Bank of St. Louis President James Bullard.

In a provocative paper from the St. Louis Fed, Bullard argued that the best way to avoid this trap is for the Fed to shift away from interest rate policy and instead focus on “quantitative easing” measures to boost inflation expectations if inflation shows signs of ticking lower.

Bullard is currently a voting member of the Fed’s policy-setting Federal Open Market Committee. But in a conference call with journalists to explain his paper, he said it wasn’t a signal that he would dissent at the FOMC’s Aug. 10 meeting if the committee maintains its standard line on rates, but rather was meant to provoke debate on the effectiveness of the current policy stance.

FOMC policy statements have over the past year and half repeated the line that economic conditions are “likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

In his paper, Bullard argued that this statement, coupled with the Fed’s target federal funds rate range of 0-to-0.25%, could backfire in its efforts to bolster expectations that loose monetary conditions will foster inflation and so avoid deflation. Noting core annual inflation of just 0.9% in May 2010, he said that there’s risk that the U.S. economy could end up like Japan’s, where both nominal interest rates and inflation remain stuck at a dangerously low equilibrium level, “an unintended, low nominal interest rate steady state.”

“Promising to remain at zero for a long time is a double-edged sword,” Bullard wrote. “The policy is consistent with the idea that inflation and inflation expectations should rise in response to the promise, and that this will eventually lead the economy back toward the targeted equilibrium of [higher nominal rates and inflation]. But the policy is also consistent with the idea that inflation and inflation expectations will instead fall, and that the economy will settle in the neighborhood of the unintended steady state, as Japan has in recent years.”

Citing the market’s interpretation of the Fed’s policy response to the European sovereign debt crisis, he argued that its “extended period” language had the perverse effect of pushing out even further the expected date on which policy conditions are normalized. This was evident in the way that Treasury Inflation-Protected Securities, or TIPS, have priced in response to the crisis.

“When the European sovereign debt crisis rattled global financial markets during the spring of 2010, it was a negative shock to the global economy, and the private sector perception was certainly that this would delay the date of U.S. policy rate normalization,” he wrote. “One might think that is a more inflationary policy, but TIPS-based measures of inflation expectations over five and 10 years fell about 50 basis points.”

In a technical paper that Bullard conceded was “geeky,” he analyzed various academic studies of how to reach the ideal “steady state.” According to data that plotted actual policy rates and inflation rates from the past decade, that equilibrium has tended to occur when inflation is at 2.3% and the nominal interest rate is at 2.8%.

He then went on to discuss the difficulty in reaching this target amid the so-called “zero bound” dilemma, a state in which interest rates are at zero and can’t physically go any lower even though consumer prices could still turn negative. The Japan experience suggests there’s a risk that economies also have far less desirable “steady state” equilibrium point in which interests are near zero while prices are in a deflationary state.

One problem, he claimed, is that central banks remain “completely committed to interest rate adjustment as the main tool of monetary policy, even long after it ceases to make sense.”

Instead, Bullard argued, the “appropriate tool” for tackling inflation expectations at such times is to expand “quantitative easing,” a policy of buying longer-dated monetary debt. The U.S. and the U.K. both applied variations of this policy amid the recent financial crisis and Japan has tried to do the same at different times.

He said higher inflation data in the U.K. suggests that the Bank of England’s program has been somewhat more effective than the Fed’s at encouraging inflation expectations, while Japan’s efforts have failed because they lack long-term credibility.

In his conference call, Bullard said he didn’t necessarily believe that the Fed should reopen the security purchases program that it concluded in March, but that it should explicitly state its willingness to do so if more extreme deflationary threats arise in the future.

“This is a matter of being ready in case something else hits,” he said in that call. “What if there’s a terrorist attack? What if there is some kind of trouble in the Asian recovery, or something like that?

In his paper, Bullard said that any policy regime shift intended to avoid a deflation trap needs to be “sharp and credible–policy makers have to commit to the new policy and the private sector has to believe the policy maker.”