Fed’s Bullard is concerned that the US may be headed towards a bad equilibrium, like Japan

The Federal Open Market Committee meeting next Tuesday promises to be the most interesting for about 12 months, since the outcome is far from certain.

The recent slowdown in the US economy seems to have caused some members of the committee to soften their stance on monetary policy, and the markets have begun to speculate about a possible easing in policy. If this comes, it is likely to be very slight, since I doubt that the Fed has seen enough evidence yet to convince them that the economy is slowing in a dangerous way.

However, some members of the committee seem to be getting increasingly worried that the US may be about to fall into a deflationary trap, like the one which has affected Japan in the last decade. James Bullard, the president of the St Louis Fed, released a very interesting paper last week which analyses the Japanese precedent in some detail. Although he does not consider this the most likely development in the US, he does think that it is sufficiently probable to require contingency planning, in much the same way as the government might prepare for a terrorist attack which it hopes and expects will not happen.

I recommend anyone interested in monetary economics to read the Bullard paper in full. It is sophisticated (as one would expect from a former senior economist in the St Louis Fed), and it could become very important for Fed policy if deflation looms. However, it is fairly complex, and may need some interpretation for non specialist economists. Here is my attempt at an interpretation, which I hope does the argument justice. Please let me know if I have over-simplified or misinterpreted.

The argument hinges on a key graph, which I have simplified and reproduced below. This graph is in turn based on original work done by Jess Benhabib and others in 2001. The graph shows two key relationships in the inflation/short term interest rate space. Both of these need to be satisfied if the economy and the Fed are to be in equilibrium. The first is the Fisher relationship, which simply states that the equilibrium real rate of interest will be a constant, so the nominal rate rises one-for-one with the inflation rate. In the graph, we have set an equilibrium real rate at 0.5 per cent, which is a reasonable guess for very short term, risk free investments. If the Fed tries to set a short rate below this level, then there will be excess expenditure in the economy and inflation will rise. And vice versa.

What rate of interest will the Fed actually set? This is shown by the Taylor Rule line. It assumes that the Fed has an inflation target of (say) 2.3 per cent, and adjusts the interest rate sharply upwards if this inflation rate is exceeded, and vice versa. Because the Fed adjusts the interest rate by more than inflation varies, this line is very steep around the target inflation rate. However, it becomes horizontal at 0.25 per cent whenever inflation falls below 1 per cent, because the Fed cannot cut short rates much below 0.25 per cent. (This is the lowest rate at which the Fed funds market will function, and anyway it is impossible to cut the policy rate below zero.)

So much for the preliminaries. The analysis gets more interesting when we observe that there is only one combination of inflation and interest rates where the economy and the Fed are both happily in equilibrium. This is at point A, where inflation is at the 2.3 per cent target, and the Fed has set an interest rate of 2.8 per cent, which means that the real short rate satisfies the Fisher relationship at 0.5 per cent. This point A is a good and stable equilibrium, and it is where the US spent much of the decade up to 2007.

However, what happens if there is a sudden shock( e.g. a credit crunch) which temporarily moves inflation to (say) just below 1 per cent? This is shown as point B, which is where the economy now finds itself. The Fed is very dissatisfied with this, so it has reduced the interest rate to 0.25 per cent. The resulting real rate of -0.75 per cent is well below the real rate which satisfies the Fisher relationship, so in theory the private sector should now begin to increase its expenditure to a level in excess of its productive capacity, and inflation should  begin to rise. When inflation reaches 2.3 per cent, we are back to the happy equilibrium at point A, so the Fed can restore short rates to 2.8 per cent. This is exactly the journey which the Fed hopes that the economy will embark upon in the next couple of years.

However, it is not the only possible journey. Another possibility might be that in the depressed conditions which have followed the credit crunch, a real interest rate of -0.75 per cent is not sufficient to stimulate private expenditure, so the inflation rate actually continues to fall. Now the economy heads from B towards C. As it does so, the Fed cannot cut short rates below 0.25 per cent, so the real interest rate now begins (perversely) to rise. This depresses the economy further, which reduces inflation still further and a vicious spiral can emerge.  (This is of course usually known as the liquidity trap.)

Mr Bullard points out that there is another point where both the Fed and the Fisher relationship are satisfied. This is marked as point C in the diagram, which is the second point at which the two lines intersect.  But unlike the happy equilibrium at point A, this is an unhappy (and actually unstable) equilibrium where deflation is now a reality (-0.25 per cent), and the Fed is still stuck at a policy rate of 0.25 per cent. The real interest rate is at the original 0.5 per cent equilibrium, but this is not a stable equilibrium. If the credit crunch has had sufficiently damaging effects on demand, deflation may continue to get worse, so the economy heads westwards along the Taylor Curve, on the left of point C. The wild west is extremely bad territory to be in – possibly irredeemably bad territory, in fact.

Usually, macro-economists have assumed that a market economy will tend to gravitate towards the happy, stable equilibrium at point A, and will not tend to move towards the unhappy, unstable equilibrium at point C. This belief was encouraged by the fact that the US and Europe found themselves mostly at point A for long periods, prior to the global financial shock. But Mr Bullard points out that Japan has found itself mired near point C ever since 2002, and shows no sign of being able to navigate away from this bad equilibrium.

The Fed will now be watching like hawks (well, actually like doves) to see whether the economy shows any tendency to shift westward from point B. If it does, then they will need to debate what form of further monetary easing makes most sense. Mr Bullard seems to favour further quantitative easing via Fed purchases of treasury securities, which he thinks could reverse the direction of the economy so that it heads back towards happy point A.

Others on the FOMC may disagree with Mr Bullard. But he has certainly given them an important and interesting analytical framework to chew upon.

Related reading:

Bernanke cautions on US recovery FT