Wednesday, August 18, 2010

Seven Faces of “The Peril” -- Deflation

By James Bullard
President, St. Louis Fed

In this paper I discuss the possibility that the U.S. economy may become enmeshed in a Japanese-style, de‡ationary outcome within the next several years.

To frame the discussion, I rely on an analysis that emphasizes two possible long-run outcomes (steady states) for the economy, one which is consistent with monetary policy as it has typically been implemented in the U.S. in recent years, and one which is consistent with the low nominal interest rate, de‡ationary regime observed in Japan during the same period.

The data I consider seem to be quite consistent with the two steady state possibilities. I describe and critique seven stories that are told in monetary policy circles regarding this analysis. I emphasize two main conclusions: (1) TheFOMC’s extended period language may be increasing the probability of a Japanese-style outcome for the U.S., and (2) on balance, the U.S. quantitative easing program o¤ers the best tool to avoid such an outcome.


The global economy continues to recover fromthe very sharp recession of 2008 and 2009. During the recovery, the U.S. economy is susceptible to negative shocks which may dampen in‡ation expectations. This could possibly push the economy into an unintended, low nominal interest rate steady state.

Escape from such an outcome is problematic. Of course, we can hope that we do not encounter such shocks, and that further recovery turns out to be robust— but hope is not a strategy. The U.S. is closer to a Japanese-style outcome today than at any time in recent history.

In part, this uncomfortably close circumstance is due to the interest rate policy being pursued by the FOMC. That policy is to keep the current policy rate close to zero, but in addition to promise to maintain the near-zero interest rate policy for an “extended period.”But it is even more than that, because the reaction to a negative shock in the current environment is to extend the extended period even further— delay the day of normalization of the policy rate farther into the future. This certainly seems to be the implication from recent events.

When the European sovereign debt crisis rattled global …nancial 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. One might think that is a more in‡ationary policy, but TIPS-based measures of in‡ation expectations over …ve and ten years fell about 50 basis points.

Promising to remain at zero for a long time is a double-edged sword. The policy is consistent with the idea that in‡ation and in‡ation expectations should rise in response to the promise, and that this will eventually lead the economy back toward the targeted equilibrium of Figure 1.

But the policy is also consistent with the idea that in‡ation and in‡ation expectations will instead fall, and that the economy will settle in the neighborhood of the unintended steady state, as Japan has in recent years.

To avoid this outcome for the U.S., policymakers can react differently to negative shocks going forward. Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.

Go Read Seven Faces of “The Peril”

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Original content Bob DeMarco, All American Investor