Thursday, July 29, 2010

Fed: Low Rates Risks Deflation in the U.S. Just Like Japan

James Bullard, Federal Reserve Bank of St. Louis President, said today that the U.S. is closer to a Japanese-style outcome today than at any time in recent history due to its low interest rate policy.

He said the central bank should resume purchases of Treasury securities if the economy slows and prices fall instead of keeping rates near zero.

National Post reports that the warning was a research paper released today written by Mr. Bullard.

“A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.” “The most likely possibility from where we sit today is that the recovery will continue through the fall, inflation will start to move up and this issue will all go away,” “Suppose we get another negative shock, another surprise. We have to be prepared in that event to have a plan in place to do something.”

He added that the' Fed's pledge to keep rates near near zero may prove to be detrimental: "While some people say rates near zero will accelerate inflation, such an interest rate policy may also cause a broad-based decline in prices".

“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,”

Mr. Bullard also added that deflation can hurt the U.S. financial system "because falling prices undermine the value of financial contracts such as mortgages".

"His comments echoed Bernanke’s research on the Great Depression indicating that declines in borrowers’ net worth can worsen a downturn".

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