By Colin Barr
July 29, 2010

The Fed is trying so hard not to scare the market that it risks putting the economy to sleep, a top Fed official said.

By promising to leave short-term interest rates near zero for an extended period, the Fed “may be increasing the probability of a Japanese-style outcome for the U.S.,” St. Louis Fed President James Bullard (right) said in a paper released Thursday. He says the best bet for avoiding that sort of slowdown is another round of Fed asset purchases.

The support for another round of asset purchases is noteworthy because Bullard has been both a supporter of Fed asset purchases and a worrier about the potential inflationary impacts. His support for more asset purchases suggests he believes the balance has swung against inflation.

Japan has endured two decades of economic stagnation after its asset price bubbles burst around 1990. It has been widely assumed this country could avoid such an outcome, but that assumption has come under fierce attack lately, with a weakening growth outlook and a sharp decline in Treasury bond yields.

The 10-year Treasury yield has dropped to around 3% from 4% this spring, and some growth skeptics now say it could tumble another percentage point or more. This decline happened even as the Fed this spring signaled it would hold rates near zero further into the future, as a response to the unrest in European debt markets.

This response appears to be “inflationary,” Bullard writes, by delaying the Fed’s exit from its two-year-old detour into the world of free money. Yet the market’s inflation expectations tumbled.

“Promising to remain at zero for a long time is a double-edged sword,” he concludes.

Bullard is the second top Fed official to part with Fed chief Ben Bernanke on the “extended period” language. Kansas City Fed chief Thomas Hoenig has called on the Fed to drop that promise and modestly raise interest rates.

Bullard said Thursday that buying Treasury securities with newly created dollars, known as quantitative easing, likely offers Fed policymakers “the best tool to avoid such an outcome.”

This is noteworthy because Bernanke, for his part, recently has danced around the question of whether the Fed will resume asset purchases.

The Fed bought $1.7 trillion worth of mortgage-related bonds and Treasury securities in the year ended this part March in a bid to fend off deflation fears in the United States.

Bullard and other regional Fed officials have worried in particular about the Fed’s heavy holdings of mortgage bonds. They could be difficult to sell at a time of economic weakness, because the sales would reduce liquidity in the economy, but could prove hard for the Fed to hold in a recovery because they lose value when interest rates rise.

Bullard and Charles Plosser of the Philadelphia Fed have advocated selling the mortgage bonds and buying Treasurys with the proceeds, in a bid to move the Fed’s balance sheet back toward its typical all-Treasurys composition.

Even were the Fed to undertake such transactions, though, its balance sheet would still be more than twice as big as it was before the crisis – reflecting a surge in the monetary base that will be difficult to withdraw without creating economic side effects.

Bullard warned in May that while a so-called exit strategy is easy to sketch out on paper, it’s much more difficult to put into practice as a result of the intense market interest in the Fed’s actions.

“In theory, any credible commitment to remove the policy in finite time will work well,” Bullard said in a speech May 28. “In practice, markets may well lose faith sooner than that.”

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