Feds Play Down Inflationary Risk, Warn of Deflation
Through credit easing efforts -- cutting the federal funds rate effectively to zero, purchasing commercial paper and buying up to $500 billion in agency MBS -- the Federal Reserve has doubled its balance sheet in the past year to just under $2 trillion, Bernanke said at a press conference Wednesday. The swelled balance sheets don't have to signal negative implications like inflation, and even indicate increased interest income "to the benefit of the federal budget," as the Fed's assets pay interest, he said. "Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation," Bernanke said. But the fact that banks are holding so tightly to some new reserves combined with an overall weak global economy cause the Fed to see "little risk of unacceptably high inflation in the near term; indeed, we expect inflation to be quite low for some time," he said. Inflation may be so low, in fact, that the pressures border on deflation. The Fed has said in the past that inflationary pressures have hovered at uncomfortably low efforts. On Wednesday Bernanke acknowledged the Fed will eventually have to begin raising the federal funds rate to moderate growth in the money supply. Credit-easing programs will also have to be relaxed to let the Fed's balance sheets shrink. Only then will the Fed be able to "return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate," Bernanke said. Federal Reserve Bank of St. Louis president James Bullard, in a speech given Tuesday at the New York Association for Business Economics, would seem to agree with Bernanke that the de-inflationary pressures risk possible deflation. But Bullard urged Fed action immediately to reverse Bernanke's "credit easing" methods and introduce "quantitative" measures starting at the monetary base. "To avoid the risk of deflation, it is important that the Fed provide a credible nominal anchor for the economy," Bullard said. "One way to do so is to set quantitative targets for monetary policy, beginning with the growth rate of the monetary base." A failure to do so may lead to deflationary effects over the next few years that could drive to higher real interest rates and an unnecessary burden on the U.S. economy and American borrowers in particular, according to Bullard. "Ongoing deflation in the United States might be particularly pernicious," he said. "Household mortgages are long-term nominal contracts. Sustained deflation increases the real debt burden of leveraged homeowners and can erode their equity. With sustained deflation, the foreclosure experience that we have seen in the subprime market could generalize to a wider spectrum of homeownership." Write to Diana Golobay at email@example.com.