Federal Reserve's James Bullard: Long-term deflation is a possibility

James Bullard is the St. Louis Fed president.
James Bullard is the St. Louis Fed president. (Tomohiro Ohsumi - Bloomberg)
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By Neil Irwin
Washington Post Staff Writer
Friday, July 30, 2010

A top Federal Reserve official warned Thursday that the nation faces the risk of an extended period of falling prices known as deflation, such as that experienced by Japan over the past two decades.

James Bullard, president of the Federal Reserve Bank of St. Louis, argues in a new paper that large-scale quantitative easing -- or purchases of government bonds and other assets by the central bank -- would be the best policy tool to prevent that possibility, though he doesn't endorse making such a move now.

In his paper, ominously titled "Seven Faces of 'The Peril,' " Bullard raises the possibility of Japan's fate befalling the United States in more explicit fashion than have his colleagues in the Federal Reserve system. He reaches the counterintuitive conclusion 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." by raising expectations that prices will remain flat for an extended period. But he also finds that "on balance, the U.S. quantitative easing program offers the best tool to avoid such an outcome."

Bullard's paper comes 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. Ironically, one of the policy options Bernanke mentioned -- pledging to keep short-term rates low for longer -- is an idea that Bullard rejects.

Bernanke said explicitly in his testimony that he does not expect the United States to experience deflation, though he also acknowledged that the economic outlook has become "unusually uncertain."

In a deflationary cycle, a weak economy leaves companies with little ability to raise prices for their goods. Falling prices lead households and businesses to hold onto cash rather than spend it, creating a self-reinforcing cycle of misery. The last time the United States experienced such a process was in the 1930s.

The Commerce Department will report Friday on second-quarter gross domestic product, which is expected to show a soft 2.5 percent pace of growth. Inflation has been lower than the Fed's target, with the consumer price index up 1.1 percent over the year ended in June (Fed officials aim for inflation of around 2 percent).

Although Bullard did not advocate immediate action, his paper leaves little doubt that he would favor action if economic data continue to weaken and inflation continues to fall. Any such policy changes are likely to face objections from other Fed policymakers, such as Kansas City Fed President Thomas Hoenig and Philadelphia Fed President Charles Plosser, who see risks of inflation and financial imbalances developing.

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