Fed Paper — Fears of Deflation

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Hi All,


My next blog entry will not be until next Wednesday. I try to do short “one-on-one” trips with each of my kids and I’m going to be traveling on Sunday and Monday.  Jenny has said that she loves the idea of these one-on-one trips as long as she doesn’t have to take one with me.


One other “kid note” for all of you with children in Texas.  The Cowboys do some of their summer camp in San Antonio (The Alamodome).  I took one of my children to practice this morning.  It’s free (parking is $10) and it’s air-conditioned.  Put it on your calendar for next summer.  Unfortunately, Friday is the last day for this summer.  The Cowboys are headed to Ohio for a week and then California for a while.  Now, on to today’s blog…


Today’s blog may sound particularly dry – I’m reviewing a paper written by the President of the St. Louis Fed.  But this is really important.  Regardless of whether you like the paper (or my summary), it tells you that people “in-the-know” are thinking about deflation and further quantitative easing and a long-term stagnant economy.


The paper that I am summarizing came out last week and has received A LOT of attention.  (Just google the author using Google News and you’ll see.)  The paper is called Seven Faces of “The Peril” and it’s written by James Bullard (President and CEO of the St. Louis Federal Reserve Bank).  Here’s a link to the paper. Bullard argues that we have a greater chance of a “Japan type” economy than we have ever had.  (Japan has been in and out of recession for twenty years and has suffered from deflation.)


He says that the US has a “steady state” equilibrium of 2.3% inflation with a nominal Fed Funds rate of 2.8% (over time).   Unfortunately, the data shows that there is a second “steady state” equilibrium point: deflation of .5% and a Fed Funds rate of .1.  This analysis is based on data that comes from Japan and the US.  In other words, he’s saying that the economy is healthy if we have moderate inflation and a moderate Fed Funds rate, but the economy could also settle in to a lower steady state (with possible deflation).


When we reach this lower steady state, we have problems. Interest rates are bounded at zero (we can’t lower the Fed Funds rate below zero).


The paper frequently refers to a chart which shows Japan’s low interest rates and low inflation as well as the fact that we are moving dangerously close to them:

Don’t forget that deflation is dangerous.  For an example of a deflationary market, look at the housing market over the past few years.  If we have deflation, it means that we’re paying back our debt with more valuable dollars.  Deflation can mean that real interest rates are higher.  In addition, the cost of labor is higher (since wages are stagnant and prices are dropping), so it could be that less labor will be utilized.

When inflation becomes very low (like we have now), the Fed has signaled that they will keep rates low for a very long time period.  The goal is to actually increase inflation.  But, at the same time, when the FOMC signals that rates will be low for a long period of time, we start to expect low inflation.  Bullard says that when rates become this low, the Fed loses control over the economy.  We need a policy which will be sharp and credible.  But in reality, no change of this sort is being discussed by the Fed.  Everyone (the Fed and investors) continue to speak about interest rates.  As a result, we have an increased chance of a Japanese type environment.  His conclusion is that quantitative easing is the best solution to this problem.


Bullard points out the seven responses to the argument that we are moving toward a Japanese-type economy:

1. Denial – Japan is different.  The Japanese political system is different and the Bank of Japan lacks political independence as well as an inflation target.




2. Stability – the targeted steady state (with 2.3% inflation) is a stable state, while the unintended steady state (with low rates) is unstable.  As  a result, we should not expect to remain at the low rate steady state.  This is another form of denial.  If you want to believe this argument, you still have to believe that Japan is somehow different than the US.




3. FOMC 2003 – if you look at the circled data in Figure 1, we had a Fed Funds rate of 1% and inflation of 1% – 1.5% and the Fed worried about deflation.  In other words, we’ve been here before and we recovered (higher inflation and higher rates).  One problem with this argument, however, is that we did not have interest rates that were zero or near zero.  During this time period, the Fed started to publicly mention the risk of low inflation (and said it was greater than the risk of high inflation).  Bullard theorizes that this signaled to the market that the Fed had identified the existing inflation rate (in 2003) as the lower boundary for inflation.  This resulted in an increase in the inflation rate.  We saw inflation expectations increase (as measured by the spread between ten year Treasuries and the ten year Treasury Inflation Protected Security).  It’s hard to know whether the Fed had brilliantly changed market expectations or the Fed was simply fortunate that the economic data supported a belief that inflation was higher than earlier expected.




4. Discontinuous – if the problem is the existence of a second, unintended steady state, and this is partly caused by the choice of a low Fed Funds rate, why not just choose a different Fed Funds rate?  In other words, we should have an accommodative policy, but still higher than zero.  An example would be a Fed Funds rate near 1.5%.  The idea is that when inflation gets low, we can’t continue to lower rates so significantly.  If you believe this, you must believe that current Fed policy is dangerous (it creates the possibility of the low steady state…which is Japan-like).




5. Traditional Policy Rule – the Bank of England never allowed rates to fall below 2% (for over 314 years!), regardless of what happened.  The idea is that the “bad” steady state is associated with a higher rate (which has a higher expected level of inflation).  The idea is to avoid a situation in which we have rates that are “too low” and we lose ability to impact the economy.  Of course, if we say rates can’t go lower than 2%, we are also losing the ability to impact the economy (sometimes for a long period of time).




6. Fiscal Intervention Given the Situation in Europe – one suggestion has been that governments could embark on aggressive fiscal expansion resulting in higher government liabilities.  In other words, the government threatens to behave unreasonably (overspending) until it forces the market to expect higher interest rates.  Bullard says that this approach is completely unreasonable after seeing how the market responded to Greece.  In addition, countries that have been on the brink of insolvency have also had terrible economic performance.  Japan has increased fiscal spending, their debt-to-GDP is now 200% and they are still in a low steady-state environment.




7. Quantitative Easing – buying our own debt, often described as “monetizing the debt.”  When the government does this, it can have a short-term impact of pushing rates down, but it pushes up inflation expectations.  To the extent that investors perceive the increase in monetary base to be long-term, it increases inflation expectations.

Bullard’s Conclusion

During recovery, we are susceptible to negative shocks which could lower inflation expectations.  It is difficult to escape from a deflationary environment.  We are closer to a Japanese-style outcome than at any time in recent history.


A lot of our problems come from the FOMC policy to keep rates near zero for an “extended period.”  We seem to react to shocks (like the problems in Europe) by promising to keep rates low for a longer period of time.  While this may sound inflationary, it seems like inflation expectations have dropped (again, comparing UST yields with TIPs).  The policy could lead to higher inflation expectations, but it may also tell the market that we have no inflation fears.  Instead of sending a signal to the market that we’re going to be in a low interest rate environment forever, we should engage in quantitative easing (if there is a negative shock).

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