–Fed Doesn’t Target Dollar, But Dollar Depreciation Expected From QE2

By Steven K. Beckner

ST. LOUIS (MNI) – St. Louis Federal Reserve President James Bullard
Thursday said he would expect the Fed’s expansion of the monetary base
through asset purchases to be inflationary if maintained over a long
period of time.

Bullard said central banks that create money through asset
purchases only temporarily face no inflationary consequences, whereas
those who do so permanently do cause inflation. He said the Fed is “in
between.”

In a presentation at a conference on quantitative easing hosted by
the St. Louis Fed, Bullard noted that, in fact, inflation and inflation
expectations in the U.S. have risen.

But he said the just-concluded second round of large scale asset
purchases or quantitative easing was justified because the U.S. last
November faced a “Japan-style” deflation risk. Japan, he said, appears
to be “stuck” in an “unintended steady state” of moderate but unhealthy
deflation.

He said “QE2″ had a “marked” and “substantial” easing impact —
“about as classic as you can get.”

Among the effects was “dollar depreciation,” Bullard said, adding
that this was an expected effect, though not an announced goal.

“Of course we’re not targeting dollar,” he said, “but you would
expect that when you ease monetary policy in the U.S. and the rest of
the world stays constant you would expect the dollar to depreciate.”

Bullard added “it’s always tricky with the dollar because other
things could be going on in other countries.”

He also cited the impact of QE2 on driving up stock prices. He said
stock prices “remain high today relative to where they were last August”
when Fed Chairman Ben Bernanke telegraphed the advent of QE2.

Elaborating on comments made in his prepared remarks and in
previous speeches, Bullard expressed reservations about committing to an
indefinite “extended period” of near zero short-term interest rates — a
policy reaffirmed at the July 22 Federal Open Market Committee meeting.

“What worries me about that piece of advice is that it could be
counterproductive,” he said. “It could send us into a Japan style
outcome.” He said there is a risk of getting “stuck” in an “unintended
steady state” of zero rates and very low inflation or deflation.

Japan’s experience shows that “if you get stuck there you get stuck
for a long time,” he said.

Bullard also addressed concerns about the potential inflationary
effect of a prolonged expansion of the Fed’s balance sheet and in turn
bank reserves and the monetary base.

“If you double the monetary base today and take it all back
tomorrow you wouldn’t expect it to have an effect on inflation,” he
said. But “if you double it and never take it back, would expect
inflation.”

“We’ve got something in between,” he said, The Fed is “taking it
back at an unspecified pace for an unspecified period.”

Quantitative easing has caused “a build-up of the monetary base,”
he said, which should be expected to lead to “higher expected inflation
… . In fact we have seen higher expected inflation. So it’s hard to
argue such a policy is neutral.”

When a central bank is merely performing its lender of last resort
role of providing short-term liquidity to financial institutions during
a crisis, there is little if any impact on inflation, he said, because
“everybody comes into the discount window … you print a bunch of money
… then they give you back the money, you give back the collateral and
you shred the money.”

But “when you go out and buy government debt, it is less clear how
temporary” the money creation is. When you buy bonds … the money is
out there in circulation,” he added.

Bullard said the central bank could have a policy where it
regularly sells the assets it has bought, or it could have a Third World
style policy of continuously buying government debt. The former would
not be inflationary, but the latter would, he said.

“We’ve got something in between a temporary and a permanent
policy,” he reiterated.

In a separate presentation, a New York Federal Reserve Bank staffer
estimated that Fed asset purchases had lowered the 10-year Treasury
yield by 60-100 basis points and also narrowed yield spreads.

** Market News International **

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