Federal Reserve member speaks of risk of Japanese-style deflation

a deflated birthday balloon

A Federeal Reserve member said Japanese-style deflation in the U.S. economy is a possibility if the Fed holds benchmark interest rates at record lows indefinitely. Robbophoto/Flickr photo.

A warning that deflation could set in as U.S. economic recovery weakens was sounded by James Bullard, the president of the Federal Reserve Bank of St. Louis, Thursday. Preventing inflation has been the focus of Federal Reserve as it formulates policies to guide the U.S. economy out of the recession. But Bullard cautioned that Fed’s current policies to stimulate growth are putting the U.S. economy at risk of falling into a Japanese-style deflationary cycle that could keep the economy weak for several years.

Deflation could result from preventing inflation

Deflation is a widespread and prolonged drop in the price of goods, services, homes, stocks and wages. The New York Times reports that the Fed has been focused on preventing inflation. Starting in 2007, the Fed lowered the benchmark interest rate all the way to zero and pumped some $2 trillion into the economy with an array of emergency loans and purchases of government debts and mortgage bonds. To buy all those assets, the Fed essentially printed money — the $1 trillion in reserves. If the reserves were withdrawn and lent out quickly, the supply of money in the economy could increase rapidly, thus triggering inflation.

A recipe for deflation

The Fed quit buying government debt in March. Since then, the U.S. economic recovery has faltered and the threat of inflation is low. Bank lending is contracting. Big companies are sitting on piles of cash. Small businesses can’t get loans. The Fed’s reserves won’t be entering the money supply anytime soon. Unemployment is high. Home sales are at record lows and home prices are falling. The big picture has people like Bullard thinking ahead to the possibility of deflation.

Japanese deflation

Deflation started in Japan in the early 1990s. A 1980s real estate bubble burst, banks took a bath on real estate loans, restricted lending and asset prices fell. Cheap imports further lowered prices. The Bank of Japan and the government tried to eliminate it by reducing benchmark interest rates. The bubble’s collapse lasted for more than a decade with stock prices bottoming in 2003. Stocks went even even lower when the global economy collapsed in 2008. In November 2009 Japan returned to deflation, according to the Wall Street Journal. Consumer prices fell in October 2009 by a near record 2.2 percent.

Benchmark interest rate a ‘double edged sword’

Deflation warnings are being sounded by Bullard, a voting member on the Fed’s main policy-setting committee, as the Fed considers additional steps it should take to stimulate the economy if the weak recovery falls back into recession. The Associated Press reports that Bullard said the Fed’s pledge to hold rates at record lows for an “extended period” is a “double-edged sword.” The pledge could make investors, businesses and ordinary people think inflation could be heading lower, which could aggravate the risk of deflation. In addition to lifting the cap on the benchmark interest rate, Bullard said resuming the purchase of government debt should be considered to prevent deflation if their is a new shock to the weakened economy.

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