St. Louis Fed Chief James Bullard: Dueling With the Deflation Demon

James BullardFederal Reserve Bank of St. Louis President James Bullard has a flair for the dramatic. He's currently a member of the interest-rate-setting Federal Open Market Committee, so whatever comments he makes about the economy carry special weight.

And his writing of a document titled "Seven Faces of the Peril," in which he lays out two possible paths for the U.S. economy, is getting plenty of attention. Down one path, he argues, is the chance that low inflation married with low interest rates may lead to the kind of deflation that crippled Japan for a decade and is considered a threat to the Japanese economy now. The other possibility is that low interest rates fulfill the Fed's stated goal of increasing market liquidity and righting the economy.

Bullard's document is an enigma at its beginning for people who aren't schooled in the history of economics. He refers to an academic paper written in 2001 called "The Peril of Taylor Rules." The Taylor rules were first presented by John B. Taylor in 1993. It comes in the form of a complex mathematical equation that covers how central bank changes of nominal rates may effect GDP. That's too simple a description, but it captures the essence of the formula.

At the center of Bullard's thesis is that dangers exist on both sides of Fed easing:
"Promising to remain at zero for a long time is a double-edged sword. The policy is consistent with the idea that inflation and inflation expectations should rise in response to the promise, and that this will eventually lead the economy back toward the targeted equilibrium. But the policy is also consistent with the idea that inflation and inflation expectations will instead fall, and that the economy will settle in the neighborhood of the unintended steady state, as Japan has in recent years."
Bullard is clearly concerned about a renewed economic slowdown in the U.S., brought on to some extent by sovereign debt problems in Europe and a potential sharp drop in GDP there.

Bullard's views aren't particularly new or original. The debate over low interest rates or the purchase of long-term paper by the Fed as two alternatives are issues that are likely debated at each FOMC meeting. But Bullard is, perhaps, more concerned about the economy now than he was a quarter ago -- and who can blame him?

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