By Steven K. Beckner

ST. LOUIS (MNI) – St. Louis Federal Reserve Bank President James
Bullard suggested Thursday that it might be risky for the Fed to
maintain its stated policy of keeping the federal funds rate
“exceptionally low … for an extended period” for too long or to
lengthen it further.

Bullard defended the Fed’s second round of quantitative easing
(“QE2″), saying it was justified last November by risks of deflation and
saying it had the expected impact on the dollar, stock prices and real
interest rates.

As for its impact on the economy, he said it is hard to disentangle
the benefits from the negative effects of various “shocks” that have hit
since QE2 was launched last November.

But, speaking at a conference on quantitative easing at the St.
Louis Fed, Bullard said QE1 and QE2 proved that the Fed can provide
monetary stimulus after it has reduced the funds rate to near zero.

When the central bank has reached the zero bound on rates, the
“conventional wisdom reaction to a negative shock” is to “lengthen the
‘extended period,'” Bullard said in prepared remarks.

But he asked, “Could such a policy be counter-productive, sending
the U.S. to the Japanese-style outcome?” The economy could find itself
in an “unintended steady state” — an intractable condition of zero
rates and “inflation consistently below target, he said, but did not
elaborate.

Bullard did not really answer his own question in prepared remarks,
but he has more bluntly warned of problems with a prolonged “extended
period” committment in the past.

For example, in a speech last August in Rogers, Arkansas when he
was arguing in favor of QE2, he warned that, though intended to
increased expected inflation, the “extended period” guidance could
actually lead the United States into a Japan-style deflation.

He contended that it could achieve the exact opposite of its
intended result. Echoing a research paper he had done earlier in the
summer, he said that keeping the funds rate near zero indefinitely could
lead to an “unintended steady state” of deflation, instead of higher
inflation.

“Keeping the policy rate near-zero may push the economy toward the
targeted steady state” of inflation in the desired 1.5% to 2.0% range,
he allowed.

“However,” he warned, “the policy is also consistent with the
unintended steady state, where there is mild deflation.”

Hence, Bullard counselled, “It may not be prudent to rely on low
policy rates alone to keep the U.S. out of the deflationary outcome.
Instead, supplement current policy with additional QE, should inflation
move lower.”

The Federal Open Market Committee reaffirmed its “extended period”
commitment in its July 22 policy statement, and in a subsequent news
conference, Chairman Ben Bernanke seemed to implicitly lengthen the
extended period by redefining the amount of time implied before the Fed
would consider tightening policy to “at least three months” instead of
“at least two months.”

Quantitative easing is effective, however, according to Bullard.

“The financial market effects of QE2 looked the same as if the FOMC
had reduced the policy rate substantially,” he said.

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

Although the financial market effects were priced in ahead of the
November decision, Bullard said that the effects of QE2 on the real
economy would be expected to “lag by six to 12 months.”

“Real effects are difficult to disentangle because other shocks hit
the economy in the meantime,” he said, suggesting that shocks such as
the spike in oil prices and European debt crisis have blurred the
effects of QE2 in the first half.

But he said disentangling the real effects “is a standard problem
in evaluating monetary policy.”

Despite those uncertainties, Bullard said “QE2 has shown that the
Fed can conduct an effective monetary stabilization policy even when
policy rates are near zero.”

Bullard maintained that “the purchase and sale of liquid assets,
such as Treasury securities, is very similar to ordinary monetary
policy, except that a particular nominal interest rate target is not
set.”

He emphasized that “balance sheet policy, like all monetary policy,
should be conducted in a state-contingent way.”

QE2 was warranted, he said, because slowing growth and falling
inflation in the summer of last year “left the U.S. at risk of a
Japanese-style outcome. The Japanese experience with mild deflation and
a near-zero nominal interest rate has been poor.”

** Market News International **

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