The debate over whether the US central bank should step up its quantitative easing program and start buying more US government debt in order to stop the country sliding into a Japanese-style deflationary quagmire suddenly became a lot more heated last night after James Bullard, the head of the St Louis Fed, and a voting member on the US Federal Reserve’s policy-making committee, released a paper which argued forcefully that central bank purchases of government debt are the best way to stimulate a weak economy stuck in a low inflation/low interest rate trap.
Bullard’s comments come at a time when there is increasing nervousness among some US politicians that the central bank is turning into a quasi-fiscal institution that is loading its balance sheets with assets of sometimes dubious quality. Last week, Ben Bernanke, head of the US Federal Reserve, appeared undecided on the need for further quantitative easing when he appeared before US Congress. And the head of the Dallas Fed, Richard Fisher, countered Bullard’s remarks overnight by saying he considered there was little the central bank could do to buoy the economy.
In the paper, titled Seven Faces of “The Peril”, Bullard warns that “the US is closer to a Japanese-style outcome today than at any time in recent history”.
Bullard argues that when both inflation and interest rates are at extremely low levels, conventional monetary policy becomes ineffective. Central banks aren’t able to cut interest rates to stimulate the economy because interest rates can’t be reduced below zero. And the markets know that interest rates won’t be increased if inflation does rise, because inflation levels are still too low.
Bullard argues that the US Federal Reserve’s current promise to keep interest rates near zero “for an extended period” is a double-edged sword. He says the policy is based on the idea that these low interest rates will eventually fuel inflation, and that this will release the economy from its current low inflation/low interest rate trap.
According to Bullard, as it recovers from the severe global recession, the US economy is extremely vulnerable to negative shocks that will dampen inflationary expectations. As a result, the economy could be pushed into a low inflation/low interest rate state. “Escape from such an outcome is problematic”, he warns.
Bullard warns that the market fully expects the US Fed to react to any negative external shock by promising to keep rates low for even longer, “which may be counterproductive because it may encourage a permanent low nominal interest rate outcome”. Instead, he argues “a better response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities”.
Bullard argued that the US Fed’s quantitative easing program in 2009 was successful in pushing up longer-term interest rates. And the Bank of England’s quantitative policy managed to push both inflation and inflationary expectations higher, “and for that reason the UK seems less threatened by a deflationary trap”.
This article first appeared on Business Spectator.
