–Bullard Worried About 2010 Disinflationary Trend
–Risk Of Creating Too Much Infln ‘A Legitimate And Important Concern’

By Brai Odion-Esene and Claudia Hirsch

NEW YORK (MNI) – St. Louis Federal Reserve President James Bullard
argued Monday that, despite numerous criticisms and concerns raised, the
need for the Federal Reserve’s recently announced asset buying program
outweighs any potential risks, especially in light of the “clear
disinflation trend” that developed this year.

In remarks prepared for a presentation at the meeting of the New
York Society of Security Analysts, Bullard gave his thoughts on why
further quantitative easing, in the form of a plan to buy $600 billion
worth of U.S. Treasuries by Q2 2011, was necessary.

Asset purchases can substitute for ordinary monetary policy,
Bullard said. “This puts downward pressure on nominal interest rates
further out the yield curve, along with upward pressure on expected
inflation. Accordingly, the policy puts downward pressure on real
interest rates.”

He argued that along with the reduced speed at which the economy
recovery came a “worrisome” disinflationary trend, one that monetary
policy would normally be used to tackle “but U.S. short-term interest
rates are already approximately zero.”

In addition, labor markets continue to be weak and Bullard said he
expects they will lag the recovery.

Again using Japan as a warning, Bullard said relying on low rates
alone to keep deflation at bay in the U.S. may not be prudent. “Instead,
supplement current interest rate policy with additional QE,” he said.

So monetary policy should be aimed at preventing further
disinflation Bullard said, noting that further disinflation with
short-term nominal interest rates at zero would mean rising real
interest rates in the face of a slowing pace of recovery.

“Defend the Committee’s implicit inflation target from the low side
as we would from the high side,” the St. Louis Fed president said.

And Bullard noted that although asset purchases are sometimes
considered unconventional, the effects that the recently announced
program has had on the financial markets “have been entirely
conventional.”

“In particular, real interest rates declined, inflation
expectations rose, the dollar depreciated, and equity prices rose,” he
said, adding, “These are the same financial market effects one might
observe when the Fed eases monetary policy in ordinary times.”

So, “In my judgment, the likely benefits outweigh the risks,”
Bullard said.

Bullard did acknowledge that easing of monetary policy produces its
maximum impact on the real economy, including output, consumption, and
investment, with a lag of six to 12 months and can be difficult to
disentangle. This is because economic performance is influenced by other
developments during this period, he said, but the real effects on the
economy from this policy action should be conventional as well.

Even though Bullard favors QE2, he also warned that the risks from
the program “are very real.”

The likelihood of creating too much inflation is “a legitimate and
important concern,” Bullard said, adding that, “If inflation were to
rise too high, the Committee might lose its hard-earned credibility for
maintaining low and stable inflation.”

So while he believes the disinflationary trend being seen this year
“is worrisome right now,” keeping inflation near the FOMC’s implicit
inflation target will be very important for maintaining credibility.

As for concerns that the Fed’s exit strategy from its massive
Treasury and mortgage-backed security holdings have become even more
complicated, Bullard said the FOMC remains committed to returning its
balance sheet to pre-crisis levels over time, adding that once this
happens the U.S. Treasury Department will be left with just as much debt
held by the public as before the Fed took any of these actions.

Bullard also used the opportunity to urge lawmakers to address the
U.S. long-term deficit problems, saying it is absolutely imperative that
the Congress and President Obama “attack” the long-run budget problems
the nation faces.

“Europe has given the U.S. an important wake-up call on how
devastating it can be to leave long-run structural deficit problems
unaddressed,” Bullard warned. ‘

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