Forex & CFD Analytics

St. Louis Federal Reserve President James Bullard said Thursday that the Fed's current policies are putting the U.S. at risk for "a Japanese-style deflationary outcome within the next several years."

While Bullard said the most likely course for the U.S. economy is a gradual recovery, if prices drop the Fed should think about buying more Treasury securities instead of promising to keep interest rates low for an "extended period."

The St. Louis chief has traditionally been a hawkish with views regarding inflation, but his recent comments may indicate a concern with deflation as the economy slows down.

"A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities," Bullard wrote in a paper released Thursday.

Bullard said that a pledge to keep the Fed's federal funds target rate near zero could be detrimental, as it could cause a decline in prices.

"Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome," he said.

Bullard's remarks come about a week after Fed Chairman Ben Bernanke told Congress that the central bank was prepared to take additional action to stimulate the recovering economy.

"The most likely possibility from where we sit today is that the recovery will continue through the fall, inflation will start to move up and this issue will all go away," Bullard told reporters. "Suppose we get another negative shock, another surprise. We have to be prepared in that event to have a plan in place to do something."

He wrote in his paper, "Promising to remain at zero for a long time is a double-edged sword," Bullard wrote. "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 of [higher nominal rates and inflation]. But the policy is also consistent with the idea that inflation and inflation expectations will instead fall."

Bullard's remarks may also indicate a growing divergence within the Federal Reserve, as Kansas City's Thomas Hoenig has recently spoken out in favor of raising interest rates.