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Fed's Bullard Sees Japanese-style Deflation Risk

Ahlevah

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James Bullard, President of the Federal Reserve Bank of St. Louis and a voting member of the policy-making FOMC, just published a paper in which he argues that the United States is at risk of moving into a new "steady state" at which the Fed will find it increasingly difficult to keep the United States out of a Japanese-style deflation. If the real core inflation rate moves to a point just below 0%, the Fed will be unable to lower nominal rates to a point at which traditional monetary policy will be effective. He argues for less Fed jawboning on keeping rates at or near 0% for an extended period, as well as a plan to resume quantitative easing, principally through Fed purchases of Treasury securities, if it appears as though the economy is weakening once again. The implications for the American economy are sobering.

St. Louis Fed Chief Bullard Worries About Deflation - Business - The Atlantic

http://research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf
 

oldreliable67

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For some additional background on the scenarios to which Bullard refers, read the CBO's "Federal Debt and the Risk of a Fiscal Crisis," here.
 

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For some additional background on the scenarios to which Bullard refers, read the CBO's "Federal Debt and the Risk of a Fiscal Crisis," here.
Japan recently began floating more bonds to cover its budget than it collects in tax revenue. Almost half the country's budget goes to two items: debt service and social security. Imagine what would happen to Japan's budget if interest rates rose.

http://www.mof.go.jp/english/budget/e20091225a.pdf
 

washunut

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James Bullard, President of the Federal Reserve Bank of St. Louis and a voting member of the policy-making FOMC, just published a paper in which he argues that the United States is at risk of moving into a new "steady state" at which the Fed will find it increasingly difficult to keep the United States out of a Japanese-style deflation. If the real core inflation rate moves to a point just below 0%, the Fed will be unable to lower nominal rates to a point at which traditional monetary policy will be effective. He argues for less Fed jawboning on keeping rates at or near 0% for an extended period, as well as a plan to resume quantitative easing, principally through Fed purchases of Treasury securities, if it appears as though the economy is weakening once again. The implications for the American economy are sobering.

St. Louis Fed Chief Bullard Worries About Deflation - Business - The Atlantic

http://research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf
Other than real estate, where is the deflation? Sounds like the key concern is continuing to bail out the banks and GSEs.
 

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Other than real estate, we are experiencing a slowing in the rate of inflation. Depending on the measure chosen, inflation appears to have decelerated to about a 1% rate, down from about 2% [emphasis on 'about,' some measures are a little higher, some a little lower]. We are not yet experiencing negative rates of change in price levels (other than the aforementioned real estate), however, the recently observed rates of increase have been slowing.

Coupled with the continuing debt pay-down by consumers, and the attendant lack-luster personal spending, it is easy to envision continued excess capacity, marginal if any improvement in employment, and thus continued pressure on prices.

While the equity markets have celebrated higher corporate earnings with generally higher stock prices, investors at some point must acknowledge that the improvement in earnings has come largely from cutbacks in overhead (reduced headcount and capacity), while gross revenues - the source of long-term growth - have grown very little, if any. Consequently, unless a source of growth can be found for gross revenues, earnings improvements will soon be much more difficult to find.

In sum, the possibility exists for a vicious cycle of reduced consumer spending to de-lever and avoid bankruptcy, followed by employment and hours reductions to try to maintain profitability, followed by reduced consumer spending, etc.. This, in a greatly simplified form, is the deflationary spiral that more are coming to fear.
 

washunut

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Other than real estate, we are experiencing a slowing in the rate of inflation. Depending on the measure chosen, inflation appears to have decelerated to about a 1% rate, down from about 2% [emphasis on 'about,' some measures are a little higher, some a little lower]. We are not yet experiencing negative rates of change in price levels (other than the aforementioned real estate), however, the recently observed rates of increase have been slowing.

Coupled with the continuing debt pay-down by consumers, and the attendant lack-luster personal spending, it is easy to envision continued excess capacity, marginal if any improvement in employment, and thus continued pressure on prices.

While the equity markets have celebrated higher corporate earnings with generally higher stock prices, investors at some point must acknowledge that the improvement in earnings has come largely from cutbacks in overhead (reduced headcount and capacity), while gross revenues - the source of long-term growth - have grown very little, if any. Consequently, unless a source of growth can be found for gross revenues, earnings improvements will soon be much more difficult to find.

In sum, the possibility exists for a vicious cycle of reduced consumer spending to de-lever and avoid bankruptcy, followed by employment and hours reductions to try to maintain profitability, followed by reduced consumer spending, etc.. This, in a greatly simplified form, is the deflationary spiral that more are coming to fear.
So no real signs of deflation. We can talk our way into a lot of problems and have an adverse impact on behavior.

You are pointing to some rather obvious issues we currently have in our economy. We were overleveraged and households took on to much debt. Much of the " deleveraging" is people being foreclosed on their homes and thus having less debt. 1% inflation is not that low considering that housing makes up a large component of the number.

I think this talk by a Fed president is a trial baloon to see if they can get this past the public. They know that housing prices still have not come down to where a real market would have them. They also know that another 7 to 10% leg down in house prices would put a lot of new pressure on banks. Greenspan talked about that yesterday on Meet the Press.

We should be concerned that the Fed has become a tool of public policy over the last 2-3 years. That is not good news for stable prices.
 

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So no real signs of deflation. We can talk our way into a lot of problems and have an adverse impact on behavior.

You are pointing to some rather obvious issues we currently have in our economy. We were overleveraged and households took on to much debt. Much of the " deleveraging" is people being foreclosed on their homes and thus having less debt. 1% inflation is not that low considering that housing makes up a large component of the number.

I think this talk by a Fed president is a trial baloon to see if they can get this past the public. They know that housing prices still have not come down to where a real market would have them. They also know that another 7 to 10% leg down in house prices would put a lot of new pressure on banks. Greenspan talked about that yesterday on Meet the Press.

We should be concerned that the Fed has become a tool of public policy over the last 2-3 years. That is not good news for stable prices.
As housing in the inflation number is calculated using implied rents, it typically understands inflation when housing is booming and overstates inflation when housing is collapsing. So during much of the 2000's the housing component of the Inflation rate was understated, and now with housing collapsing it is overstating it.


Lastly we have China and India generally to thank for raw material prices remaining at fairly high valuations. Without their increasing demand for oil, metals and even agricultural products their prices would have dropped drastically.

One last thing. Demand has been kept up for many basic products through government borrowing, the hugely extended Unemployement benifits has lept consumer demand up for an extended period of time, should UI benifits be cut, demand will drop and deflation risks will rise
 
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oldreliable67

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So no real signs of deflation.
Correct. As I said, so far, we have observed a slowing in the rate of increase, not outright declines.

Much of the " deleveraging" is people being foreclosed on their homes and thus having less debt.
Depends on your definition of "much." Take a look at the G17 and you'll see considerable reductions in all other categories as well.

1% inflation is not that low considering that housing makes up a large component of the number.
Inflation excluding housing (i.e., the imputed rent component) is decelerating. In fact, though still positive year/year, the CPI for All Items Less Shelter was down 0.1% for Mar/Apr, and down 0.3% for both Apr/May and May/June.

I think this talk by a Fed president is a trial baloon to see if they can get this past the public. They know that housing prices still have not come down to where a real market would have them. They also know that another 7 to 10% leg down in house prices would put a lot of new pressure on banks. Greenspan talked about that yesterday on Meet the Press.
A trial balloon, possibly. Regardless, Bullard's statements are important because: one, he is a voting member of the FOMC; and two, he had previously been much more hawkish, hence this is a change of position for him. Consequently, this publicly stated position suggests that the FOMC will give much more weight to the risks of deflation at next weeks meeting. My guess is that a slight change in language will be forthcoming, something like a commitment to keep the size of the Federal Reserve's balance sheet "at a high level," instead of the current policy of allowing maturities/prepayments in the MBS portfolio to run off without replacement. This would represent an acknowledgement of the deflationary risk with only a small accomodation. Should the FOMC not make this small accomodation/acknowledgement, look for a non-trivial discussion of the deflationary risk in the minutes.

We should be concerned that the Fed has become a tool of public policy over the last 2-3 years. That is not good news for stable prices.
The Fed has always been a tool of public policy, one way or another. The Fed's vaunted/prized independence exists at the leisure of Congress; don't think for a minute that that is not always kept in mind down on Constitution Ave.
 
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washunut

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As housing in the inflation number is calculated using implied rents, it typically understands inflation when housing is booming and overstates inflation when housing is collapsing. So during much of the 2000's the housing component of the Inflation rate was understated, and now with housing collapsing it is overstating it.


Lastly we have China and India generally to thank for raw material prices remaining at fairly high valuations. Without their increasing demand for oil, metals and even agricultural products their prices would have dropped drastically.

One last thing. Demand has been kept up for many basic products through government borrowing, the hugely extended Unemployement benifits has lept consumer demand up for an extended period of time, should UI benifits be cut, demand will drop and deflation risks will rise
The global pressure on commodities will not deminish only go higher. So just like inflation was muted for the last twenty years due to low labor rates in China it will have the opposite impact now. In addition, labor rates in China are rising so prices for their product will not go down going forward.

People tend to overstate the impact on such things as the unemployment benefits. They are about $30 billion on a $13 trillion economy, not much.

Ask people who go to the supermarket if they see prices going down, or when they go to the doctor.

Talk of deflation is just a smokescreen for those who want to toss some more "stimulus" money into the sinkhole. This economy is coming out of a Financial recession. The dollars that artifically inflated our economy are gone.
 

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The global pressure on commodities will not deminish only go higher. So just like inflation was muted for the last twenty years due to low labor rates in China it will have the opposite impact now. In addition, labor rates in China are rising so prices for their product will not go down going forward.

People tend to overstate the impact on such things as the unemployment benefits. They are about $30 billion on a $13 trillion economy, not much.

Ask people who go to the supermarket if they see prices going down, or when they go to the doctor.

Talk of deflation is just a smokescreen for those who want to toss some more "stimulus" money into the sinkhole. This economy is coming out of a Financial recession. The dollars that artifically inflated our economy are gone.
Note, core inflation was mentioned, and it has been in steady disinflation for some time now. The CPI on the other hand is more vulnerable to the swings in commodity prices you are speaking of.
 

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James Bullard, President of the Federal Reserve Bank of St. Louis and a voting member of the policy-making FOMC, just published a paper in which he argues that the United States is at risk of moving into a new "steady state" at which the Fed will find it increasingly difficult to keep the United States out of a Japanese-style deflation. If the real core inflation rate moves to a point just below 0%, the Fed will be unable to lower nominal rates to a point at which traditional monetary policy will be effective. He argues for less Fed jawboning on keeping rates at or near 0% for an extended period, as well as a plan to resume quantitative easing, principally through Fed purchases of Treasury securities, if it appears as though the economy is weakening once again. The implications for the American economy are sobering.

St. Louis Fed Chief Bullard Worries About Deflation - Business - The Atlantic

http://research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf
I understand the argument for quantitative easing, however I think we should be careful. When the fed uses quantitative easing to buy US Tresuaries, that is the equivalent of monetizing debt. It could be a good thing for the economy in this case, but it should always remain an exception IMO. The fed could consider buying other assets in the private market like what was done in its mbs purchasing program, however, there are significant risks with this aswell.
 

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Correct. As I said, so far, we have observed a slowing in the rate of increase, not outright declines.



Depends on your definition of "much." Take a look at the G17 and you'll see considerable reductions in all other categories as well.



Inflation excluding housing (i.e., the imputed rent component) is decelerating. In fact, though still positive year/year, the CPI for All Items Less Shelter was down 0.1% for Mar/Apr, and down 0.3% for both Apr/May and May/June.



A trial balloon, possibly. Regardless, Bullard's statements are important because: one, he is a voting member of the FOMC; and two, he had previously been much more hawkish, hence this is a change of position for him. Consequently, this publicly stated position suggests that the FOMC will give much more weight to the risks of deflation at next weeks meeting. My guess is that a slight change in language will be forthcoming, something like a commitment to keep the size of the Federal Reserve's balance sheet "at a high level," instead of the current policy of allowing maturities/prepayments in the MBS portfolio to run off without replacement. This would represent an acknowledgement of the deflationary risk with only a small accomodation. Should the FOMC not make this small accomodation/acknowledgement, look for a non-trivial discussion of the deflationary risk in the minutes.



The Fed has always been a tool of public policy, one way or another. The Fed's vaunted/prized independence exists at the leisure of Congress; don't think for a minute that that is not always kept in mind down on Constitution Ave.
I agree that his statements are important and that seems to be a change for him. I readily acknowledge that he is far wiser on this subject than I.

I am somewhat concerned that the Fed, in trying to reignite the economy seems to be pulling on a string. The excesses of the last twenty years are painful to burn off as our friends in the EU feel as well. It seems that the folks in the EU may be ahead of us in understanding that they will have to let the air out of the baloon a bit to avoid a harsher fate in the future. We still seem to be hung up too much on the short term. This not only " kicks the can" down the road but makes what will have to be adjustments all the more painful down the road.

I always have on my mind the future for our 19 year old son. It does not seem fair that this generation lives well and then passes the bill along to the next generation.
 

Kushinator

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Krugman had a quality article on deflation.

And when that happens, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. That’s the deflationary trap we keep worrying about.

A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum affair, since creditors experience a corresponding gain. But as Irving Fisher pointed out long ago (pdf), debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. So deflation exerts a depressing effect on spending by raising debt burdens – which, as Fisher also points out, can lead to another kind of vicious circle, in which depressed spending because of rising real debt leads to further deflation.
Why Is Deflation Bad? - Paul Krugman Blog - NYTimes.com
 

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Not sure where Krugman sees deflation, other than housing. We do not see it in foodstuffs, services, auto or even labor costs. Seems to me this is a strawman arguement. A backdoor approach to get what Krugman has been calling for which is a third stimulus package.

This is not to say that a full scale deflationary environment would be good, just that it does not seem to be a realistic worry.

Keep in mind that in a global economy the world gets to bid for corn from the U.S. and oil from the middle east. It is not only the spending pattern here in the states that impacts pricing. For example while there is a lot of underemployment in the U.S., in China workers are getting large raises.
 

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Not sure where Krugman sees deflation, other than housing. We do not see it in foodstuffs, services, auto or even labor costs. Seems to me this is a strawman arguement. A backdoor approach to get what Krugman has been calling for which is a third stimulus package.
We do not see it yet. Just give it time. I'll bet my sweet bippy it's coming.
 

washunut

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We do not see it yet. Just give it time. I'll bet my sweet bippy it's coming.
What would I have to put up against your sweet bippy?!
 

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What would I have to put up against your sweet bippy?!
Nothing other than bragging rights in, say, a year? If some time within the next year we get a decline in the CPI over a rolling twelve month period I win. You'll be giving me a bit of a handicap, since I've got a string of three declines in a row. :2razz:
 
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washunut

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Nothing other than bragging rights in, say, a year? If some time within the next year we get a decline in the CPI over a rolling twelve month period I win. You'll be giving me a bit of a handicap, since I've got a string of three declines in a row. :2razz:
OK you are on. Oil and commodities should overcome pretty flat housing costs.
 

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In an earlier post, I wrote that I suspected that, at the FOMC meeting next week, the Fed would opt for "a slight change in language...something like a commitment to keep the size of the Federal Reserve's balance sheet "at a high level," instead of the current policy of allowing maturities/prepayments in the MBS portfolio to run off without replacement." Today's WSJ agrees, saying,

"Federal Reserve officials will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week to ponder an economy that seems to be losing momentum.

The issue: Whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead. Any change—only four months after the Fed ended its massive bond-buying program—would signal deepening concern about the economic outlook. If the Fed's forecast deteriorates significantly, it could also be a precursor to bigger efforts to pump money into the economy."
 

washunut

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In an earlier post, I wrote that I suspected that, at the FOMC meeting next week, the Fed would opt for "a slight change in language...something like a commitment to keep the size of the Federal Reserve's balance sheet "at a high level," instead of the current policy of allowing maturities/prepayments in the MBS portfolio to run off without replacement." Today's WSJ agrees, saying,

"Federal Reserve officials will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week to ponder an economy that seems to be losing momentum.

The issue: Whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead. Any change—only four months after the Fed ended its massive bond-buying program—would signal deepening concern about the economic outlook. If the Fed's forecast deteriorates significantly, it could also be a precursor to bigger efforts to pump money into the economy."
Interesting what the words slight or modest mean these days.

If the Fed were to replenish mortgages that mature or are otherwise retired that would be about $200 billion a year. About the size of the congressional stimulus. This seems to be a continuation of the bank bailouts of 2 years ago.

Never thought I would say it, but maybe it is time for the Fed to be abolished.
 

washunut

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In an earlier post, I wrote that I suspected that, at the FOMC meeting next week, the Fed would opt for "a slight change in language...something like a commitment to keep the size of the Federal Reserve's balance sheet "at a high level," instead of the current policy of allowing maturities/prepayments in the MBS portfolio to run off without replacement." Today's WSJ agrees, saying,

"Federal Reserve officials will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week to ponder an economy that seems to be losing momentum.

The issue: Whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead. Any change—only four months after the Fed ended its massive bond-buying program—would signal deepening concern about the economic outlook. If the Fed's forecast deteriorates significantly, it could also be a precursor to bigger efforts to pump money into the economy."
Interesting what the words slight or modest mean these days.

If the Fed were to replenish mortgages that mature or are otherwise retired that would be about $200 billion a year. About the size of the congressional stimulus. This seems to be a continuation of the bank bailouts of 2 years ago.

Never thought I would say it, but maybe it is time for the Fed to be abolished.
 

Ahlevah

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OK you are on. Oil and commodities should overcome pretty flat housing costs.
You're assuming commodity prices (including oil) will continue to climb from their lows. I don't take that as a given. And even if commodities' prices manage to buck strong headwinds coming from weakness in end demand in the United States and Europe, there's no guarantee that companies will be able to pass those costs on to the U.S. consumer, who's still suffering from a nose bleed to the tune of $11 trillion while he continues to see the value of his largest single asset--his home--under pressure. If the stock market goes into another major decline, he'll have to overcome a one-two punch again when he's already on his knees.

http://www.federalreserve.gov/releases/z1/current/z1.pdf

Consumer Spending and Incomes in U.S. Stagnate - Bloomberg
 

oldreliable67

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washunut said:
that would be about $200 billion...About the size of the congressional stimulus
The Bush stimulus was about 200B; the Obama stimulus was 787B.

What would you propose in place of the Fed to carry out monetary policy?
 

Ahlevah

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The Bush stimulus was about 200B; the Obama stimulus was 787B.
Let me just point out that all of the Federal "stimulus" is chump change compared to the amount of credit destruction taking place. And I don't think it's effective in any case:

While there is credible evidence that during the post-Korean War era the expenditure multiplier was zero, other research has produced slightly different results. For instance, during the extraordinary conditions of World War II and the Korean War the multiplier has been calculated as .6, meaning that a $1 rise in government spending would lift the economy as a whole by 60 cents while reducing private spending by 40 cents. Valerie A Ramey, Professor of Economics at the University of California at Berkeley has found that the expenditure multiplier is in a range of 0.6 to 1.1, or an average of .85. Once again this suggests some boost to overall economic activity from government spending at the expense of the private sector. The estimates of the multipliers vary due to different sample periods and other technical considerations. The objective is to identify the effects of government spending on economic activity while over time a host of other influences are also at work. The center of the estimates of the spending multiplier, however, is less than one, while the center of estimates for the tax multiplier, our next topic, is greater than one. Consequently, economic conditions will ultimately deteriorate in response to the current fiscal policy mix.

http://www.hoisingtonmgt.com/pdf/HIM2010Q1NP.pdf
 
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washunut

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You're assuming commodity prices (including oil) will continue to climb from their lows. I don't take that as a given. And even if commodities' prices manage to buck strong headwinds coming from weakness in end demand in the United States and Europe, there's no guarantee that companies will be able to pass those costs on to the U.S. consumer, who's still suffering from a nose bleed to the tune of $11 trillion while he continues to see the value of his largest single asset--his home--under pressure. If the stock market goes into another major decline, he'll have to overcome a one-two punch again when he's already on his knees.

http://www.federalreserve.gov/releases/z1/current/z1.pdf

Consumer Spending and Incomes in U.S. Stagnate - Bloomberg
I agree that the above is my crystal ball we will see if I am correct. When it comes to foodstuffs I think you will find that increases will make their way to the end consumer. Oil the same.
 
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