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Views: Dial “M” for Monetary Policy, Says Bullard

Wednesday, April 1, 2009

St. Louis Fed President Jim Bullard warned Feb. 17 that the U.S. runs the near-term risk of falling into a deflationary trap, which could cause the U.S. housing market to further deteriorate and prolong the recession.

“A key near-term risk for 2009 is disinflation and possibly deflation,” Bullard said in a speech to the New York Association of Business Economics’ Harvard Club in New York City. “With sustained deflation, the foreclosure experience that we have seen in the subprime market could generalize to a wider spectrum of homeownership.”

In normal times, the standard central bank policy response to very low inflation has been to establish a lower effective target for a short-term nominal interest rate. In the current environment, however, because the intended federal funds rate is effectively zero, the Fed cannot lower nominal interest rates further; so, a more systematic approach is needed.

“To avoid the risk of deflation,” as it has been experienced in Japan, “it is important that the Fed provide a credible nominal anchor for the economy,” Bullard said. “One way to do so is to set quantitative targets for monetary policy, beginning with the growth rate of the monetary base.”

Bullard said that the Fed could signal that it intends to avoid the risk of deflation and the possibility of a deflation trap by expanding the monetary base at an appropriate rate. Although the impact that a change in the monetary base would have in the economy cannot be measured as precisely as that of a change in the nominal interest rate target, “the effects are unmistakable and every bit as powerful,” he added. “This channel can be used to support the committee’s medium-term inflation objective and head off a possible global deflation trap and the counter-productive rise in real interest rates that would accompany that outcome.”

Since September 2008, the Fed has injected an astonishing amount of reserves into the banking system in response to the intensified financial turmoil. “This is the normal central bank response to severe financial market distress such as that experienced in 1998 or 2001. However, the scale of the response this past fall dwarfed that of these earlier events, and the crisis has persisted much longer than in earlier episodes,” said Bullard.

The increase in the Fed’s balance sheet can be divided into two components—persistent and temporary. The liquidity injections associated with the lender-of-last resort function of monetary policy are of temporary nature and can be reversed. “Much, but not all, of the recent increase in the balance sheet can reasonably be viewed as temporary. The outright purchases of agency debt and MBS (mortgage-backed securities) are likely to be more persistent, however, and it is these purchases that may provide enough expansion in the monetary base to offset the risk of further disinflation and possible deflation,” said Bullard.