St. Louis Fed President James Bullard on Deflation

The President of the Federal Reserve Bank of St. Louis, James Bullard, has put out on the web a "preprint" of an article for the September-October issue of the FRBSTL Review entitled "Seven Faces of 'The Peril."   That Bullard, who has been known as an inflation hawk, now expresses concern about deflation seems to signal that the Fed is ready to do something if it materializes, though there does not appear to be any unanimity among Fed officials that this is likely to happen.

The article, though, is a bit perplexing.  Bullard points out the obvious; there is a zero-bound limiting what the Fed can do with interest rate targeting to combat deflation.  He also says that the Federal Open Market Committee, of which he is currently a voting member, may be making things worse by saying that the Fed is likely to keep interest rates very low for an extended period.  This may, he says, move the U.S. economy to an equilibium point of low nominal interest rates and deflation. He apparently thinks that the Fed's statement may cause the private sector to form expectations that this will happen which will be self-fulfilling.  I do not find this reasoning persuasive.  If Bullard wants to make this case, he needs to expand his discussion of this point.

Obviously, though, Bullard is right that the Fed can still expand the monetary base even if it is not targeting nominal rates.  This is called "quantitative easing," a term which serves to obscure the fact that the Fed uses its ability to create money and to extinguish it when it is targeting interest rates.  If the Fed wants to lower the fed funds rate or to increase the monetary base in a situation where the fed funds rate cannot go lower, it will expand its balance sheet, usually by buying securities.  (It can also make loans, but this has not been a major tool of monetary policy, though the discount window is used to help out commercial banks, and, in some cases, other financial institutions which face liquidity problems.)

Mr. Bullard does not go into the relative merits of  what maturity of Treasury securities the Fed should consider buying when trying to expand the monetary base.  For example, if the Fed were to buy more long-term Treasuries, this would have implications for Treasury debt management, since it would affect the maturity structure of outstanding marketable Treasury securities held by the public (not including the Federal Reserve Banks).  It is conceivable that the Treasury would consider issuing a greater proportion of its debt at the longer end in response to such a policy.  Mr. Bullard does not address this issue, nor does he discuss whether the Fed would be trying to flatten the yield curve through a quantitative easing policy.  (Whether or not the Fed, or the Fed and the Treasury acting in concert, can affect the shape of the yield curve is an unsettled issue.  The evidence from an attempt to do this, "Operation Twist" of the 1960s, is inconclusive because Treasury debt management worked at cross purposes to the Fed's open market operations.)

Bullard also does not discuss the decline in the M1 money multiplier, which compares the monetary base and the M1 measure of the money supply.  The St. Louis Fed has a chart of this decline and a table of the data on its website.  The multiplier is now a bit over 0.8, which means that the monetary base is larger than the M1 measure of money held by the public.  Prior to the last quarter of calendar year 2008, the multiplier had been in the 1.6 to 1.7 range for a number of years.  This decline in the multiplier has implications for the effectiveness of monetary policy that Bullard could have discussed.

Also, Bullard too easily dismisses fiscal expansion as a policy tool in the U.S. context.  He looks at the sovereign debt problems in Europe and concludes:  "The history of economic performance for nations actually teetering on the brink of insolvency is terrible.  This does not seem like a good tool to use to combat the possibility of a low nominal interest rate steady state."  He also goes on to state that Japan's "aggressive fiscal expansion" has not worked.  The U.S. is not on the brink of insolvency, and he should have discussed what he thinks are the reasons fiscal policy has not worked in Japan and how these are relevant to the U.S.

It is significant that a member of the FOMC is thinking about deflation and what the Fed can do about it should it occur.  If deflation does happen, I suspect that the Fed will do what it can through quantitative easing.  I also suspect that, if the deflation seems to be locked into place, the politics of deficit spending will radically change and there will be fiscal expansion, probably through some combination of increased spending and tax cuts.  The deficit hawks need to know that the only way their concerns about long-term fiscal issues can be addressed is by getting the economy to grow again.  A sustained deflationary period would be a disaster.