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Lost in deflation

Karen Maley

Published 7:40 AM, 30 Jul 2010 Last update 10:07 AM, 30 Jul 2010


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”.



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5 Comments


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Zelko Mustac wrote:

The error in logic here is that by providing enormous liquidity economic activity will proportionally increase.

(See Lost in deflation, July 30)

In Japan it did not and the Western world is likely entering a period of reduced economic growth. This is related to the decline in the productive part of the population, people aged between 20 and 55. The Baby Boom generation is past its peak in spending and will instead be increasingly drawing on savings. This has been the demographic fact that Japan has not been able to escape. GNP per capita will struggle in the Western world for the same reason. Additionally there is a long-term innovation cycle which is maturing – electronic technology such as the internet, motor cars, consumer electronics and with that peak of economic activity behind us the West will enter a long period of sluggish economic activity. This will make the debt of countries in the EU and USA harder to pay off. Even Japan, which has funded its government debt by domestic savings, will find it increasingly difficult to continue to do so as the Japanese demographic ages and draws on its personal savings for personal expenses.

The Fed Reserve, like most economists, fails to see the paradigm shift and will continue to pursue policies that have already demonstrably failed in Japan and will make the consequent economic downturn even worse.

30 Jul 2010 10:50 AM

Brian Crooks wrote:

Until the US government introduces laws to force companies to pay sustainable wages, no growth will come into the US economy, resulting in stagflation, falling domestic consumption, house repossessions, and falling car sales. Common sense says that you cannot spend what you do not have. Low taxes and low interest rates will only make a bad problem worse, but as usual, nothing will be done till a total collapse of the U.S economy happens, dragging every one down with them, as usual.

30 Jul 2010 12:29 PM

Sue Zurk wrote:

Good on ya, Zelko (See A Japanese deflation lesson, Conversation contribution, July 30). We need a new economic model. Lost in deflation shows the absurdity of hoping that the tail will wag the dog.

It's unbelievable to read that people are wishing for high interest rates and inflation. Really, we should be in heaven at the moment with the current low inflation and interest rates.

My belief is that we are entering a period where the worker will be king. It will no longer be possible to live off interest, and income will have to be generated by labour.

30 Jul 2010 7:58 PM

Sean Gurney wrote:

There is still a ton of activity going on to support the US at nearly 90 per cent employment (See Lost in deflation, July 30).

For a country so large and so pummelled by the GFC, that's actually excellent.

There are millions being made in bold new ventures, especially through intelligent I-help-you-you-help-me bartering and direct-response marketing. It is just a shame some of the older industries are in decline, thereby making net growth in the US a flat zero (or small decline) for the time being. Wait and see; the US will once again prosper.

30 Jul 2010 9:38 PM

Ben O'Grady wrote:

Economics is about the use of scarce resources (See Lost in deflation, July 30).

This is the same as the role of politics in society. Therefore, all economics is political.

There are labour and liberal economists [and economic theories] just as there are labour and liberal politicians. Their recommendations fit in with their personal perspectives and politics.

It is not surprising that most of the economists getting air-time at present, with Labour governments predominating world-wide, have leftist viewpoints.

Sadly, very few socialist countries have ever been successful economically. Think about this when you decide if we should listen to them or give them any more airtime.

At the very least, responsible media organisations will balance the two viewpoints!

31 Jul 2010 1:25 AM



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