WASHINGTON -- In an unusual move, the president of the Federal Reserve Bank of St. Louis released a paper Thursday warning that the Fed's policy of keeping interest rates near zero during the economic crisis may lead to Japanese-like deflation in coming years.
Japan has been mired in a long economic slump with low growth and falling prices, or deflation. The St. Louis Fed President James Bullard warned that absent more aggressive moves to spark its own slowing economy, the U.S. could be in for similar debilitating deflation. The Fed targets its benchmark interest rate at between zero and a quarter percentage point.
"Promising to remain at zero for a long time is a double-edged sword," he warned, saying that the Fed's effort to stimulate the economy that way may have the unintended consequence of anchoring expectations for falling prices.
In deflation, asset prices fall, and a downward spiral takes hold, where businesses and consumers hoard cash on the assumption that prices will be lower soon. That leads to a stall in economic growth, or contraction, and jobs and income are lost in a vicious spiral down.
Those who fear deflation point to the trend in core U.S. inflation, a measure that strips out volatile food and energy prices. Through June, core inflation was running at a year-over-year rate of 0.9 percent, the lowest since 1966, and below the Fed's target rate of 1 percent to 2 percent annually.
"The U.S. is closer to a Japanese-style outcome today than at any time in recent history," Bullard wrote in his paper titled "Seven Faces of 'The Peril."' The title references an academic paper on the perils in monetary policy.
Bullard argues that by holding its benchmark lending rate near zero for more than 18 months, and by promising to do so for the indefinite future, the Fed has wet gunpowder. The effort may have failed to stimulate the economy sufficiently to power it forward, and public expectations for inflation may fall. Unanchored expectations could become a self-fulfilling prophecy of downward prices.
A better way to stimulate economic growth now, Bullard argued, is to have the Fed aggressively buy up government debt. Economists call this process quantitative easing; it has the effect of printing more money because it increases the supply of money in the economy. That stimulates both inflation and expectations of future inflation.
By purchasing government debt, the Fed also would seek to drive down the return to investors, called the yield, forcing them to take risks in the economy in search of a higher return, promoting growth in the process.
The Fed tried this at the start of the crisis with some success. During a period of late 2008 and early 2009, the Fed purchased securities backed by U.S. mortgages and car loans, and other forms of debt, including U.S. Treasuries. The result was lower interest rates for companies and consumers, especially homeowners, and economic activity.