`Liquidity Trap' Plagues U.S., More Stimulus Is Required, Fed's Evans Says

http://www.bloomberg.com/news/2010-10-16/-liquidity-trap-plagues-u-s-more-stimulus-is-required-fed-s-evans-says.html
`Liquidity Trap' Plagues U.S., More Stimulus Is Required, Fed's Evans Says
By Vivien Lou Chen and Joshua Zumbrun, Bloomberg - Oct 16, 2010 2

Federal Reserve Bank of Chicago President Charles Evans

Federal Reserve Bank of Chicago President Charles Evans said, “Job loss and unemployment are now causing more defaults than imprudent lending.” Photographer: Jin Lee/Bloomberg

Federal Reserve Bank of Chicago President Charles Evans said the U.S. is in a “bona fide liquidity trap” and needs “much more” monetary accommodation in the face of high unemployment and inflation that’s too low.

“If you reach the conclusion that we are in a liquidity trap, or even near a perilous liquidity trap, more accommodation is not data-dependent or a close call,” the regional bank chief said in a speech in Boston today. He advocated targeting a path for the price level as a way to stop the inflation rate from falling.

Central bankers, seeking ways to boost flagging growth after lowering interest rates almost to zero and buying $1.7 trillion of securities, are weighing strategies for raising inflation expectations as well as expanding the balance sheet by purchasing Treasuries, according to minutes of the Fed’s Sept. 21 meeting released this week.

Fed Chairman Ben S. Bernanke said yesterday that there appears to be a “case for further action.” Some regional Fed presidents, including Philadelphia’s Charles Plosser, have questioned the need ease monetary policy further.

“I believe the U.S. economy is best described as being in a bona fide liquidity trap,” Evans said to the Boston Fed’s 55th Economic Conference. “This belief is not a new development for me; instead it is a dawning realization.” In a liquidity trap, additions to the money supply fail to stimulate the economy.

Easing Steps

The bank president’s comments are among the strongest of any Fed official in favor of additional easing steps. With projections for unemployment to be at 8 percent and for inflation excluding food and energy to be at 1 percent by the end of 2012, “the Fed’s dual mandate misses are too large to shrug off,” Evans said.

He gave his support to a target for the path of the price level over a “reasonable period of time” that is communicated “regularly and often” to the public. Such a policy could complement large-scale asset purchases and a change to the Federal Open Market Committee’s statement to include a pledge to keep rates near zero for longer than “an extended period.”

Targeting a path for the price level would help the Fed push inflation higher “for a time,” Evans said. The central bank would need to state the terms for exiting the policy, he said.

“I’ll admit that my views on this are evolving,” Evans said in response to audience questions. “I think it could be conveyed credibly but there’s a lot of work to establish that and think through what the operational characteristics of this would be.”

Lower Inflation

Some Fed officials are concerned that expectations of lower inflation will become self-fulfilling, damping demand by increasing borrowing costs in real terms, minutes of the September meeting said. By encouraging Americans to believe prices will start rising at a faster pace, the Fed would reduce inflation-adjusted interest rates and stimulate the economy.

Boston Fed President Eric Rosengren said today that Japan’s battle with deflation shows policy makers should take action to stimulate growth before price levels drop.

“Insuring against the risk of deflation may be much cheaper than waiting until it has occurred and then trying to address it,” Rosengren said in a speech at the conference.

The Bank of Japan pledged last week to keep its benchmark interest rate at “virtually zero” until deflation has ended, after first introducing the rate policy in 1999. Japan also created a fund to buy government debt and other assets.

‘Battling Deflation’

“The fact that Japan is still battling deflation highlights how pernicious deflation can be, and how difficult it is to counteract once it has been firmly established,” Rosengren said.

In the minutes, the Fed gave several options for raising short-term price expectations, including providing more information on the inflation rate policy makers consider consistent with their long-term goals and targeting a path for the price level. For the first time, the Fed said it could also target a path for nominal gross domestic product, which isn’t adjusted for inflation.

Treasuries fell yesterday, driving 30-year yields to a two- month high, and the Dollar Index rebounded from its 2010 low amid confidence Bernanke will succeed in stoking inflation. U.S. stocks rose as technology shares rallied, overshadowing losses in banks and General Electric Co.

Evans, 52, has led the Chicago Fed since September 2007 and doesn’t vote on the rate-setting FOMC this year. He votes every other year on the FOMC, as does Cleveland Fed President Sandra Pianalto.

To contact the reporters on this story: Vivien Lou Chen in San Francisco at vchen1@bloomberg.net; Joshua Zumbrun in Washington at jzumbrun@bloomberg.net.

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net