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News Analysis

A New Quandary for the Federal Reserve: Grappling With Low Inflation

BOSTON — A situation the Federal Reserve has long feared has come to pass: the central bank, after spending three decades taming inflation, now needs more of it.

And so the Fed is having to shift substantially from the approach that has come to define it and from which it has long derived its institutional self-esteem.

“In the 1980s and 1990s, few ever questioned the desired direction for inflation — lower was always better,” Ben S. Bernanke, the Fed chairman, said at a conference here this weekend, acknowledging the sea change in the Fed’s orientation.

Since the summer, Fed officials have grown increasingly worried that the United States could slip into deflation, a decrease in prices of the kind that has bedeviled Japan since the late 1990s.

That worry has taken center stage as Mr. Bernanke prepares the markets for a widely expected new round of unorthodox actions, starting in November, to prop up the recovery by lowering long-term interest rates. Nearly two years ago, the Fed lowered short-term interest rates to essentially zero.

The Fed is legally required to try to keep prices stable and maximize employment. Those often conflicting goals are, for the time being, no longer in tension as the economy limps along. In framing his cautious arguments for additional Fed action, Mr. Bernanke said inflation (about half of the implicit target of “about 2 percent or a bit below”) was “too low” and that unemployment (9.6 percent) was “clearly too high.”

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Ben Bernanke, chairman of the Fed, and Eric Rosengren, president of the Boston Fed.Credit...Adam Hunger/Reuters

Mr. Bernanke returned to Washington after giving the opening speech at the conference, organized by the Federal Reserve Bank of Boston, on “Revisiting Monetary Policy in a Low-Inflation Environment.” Had he stayed through the weekend, he would have heard colleagues expressing even graver anxieties.

Drawing on Japan’s experiences with low but persistent deflation, Eric S. Rosengren, president of the Boston Fed, said it seemed that the disease was much easier to prevent than cure. But getting Fed policy makers to agree on a course of action “has turned out to be extremely challenging,” he added.

Charles L. Evans, president of the Chicago Fed, said at the conference that he had had “a dawning realization” that the economy was in a “liquidity trap” — a situation in which monetary policy is unable to stimulate the economy by lowering interest rates or expanding the money supply. He announced his support for a much-debated strategy known as “price-level targeting,” in which the Fed would permit inflation to run at higher-than-normal rates in the future to make up for inflation being lower than desired today.

Fed officials closely monitor the markets’ beliefs about future price movements because inflation expectations can become self-fulfilling. Since the recession began in 2007, those expectations have largely remained stable.

But Richard H. Clarida, an economist at Columbia, warned that the Fed should not take a premature victory lap.

“That expected inflation has thus far adjusted only modestly lower during this cycle may be the result not of Fed credibility to generate inflation in the future, but instead may be the result of the fact that the Fed in the past has delivered 2 percent inflation,” he wrote in a paper presented here.

He added: “Expectations of disinflation or even deflation could become entrenched as they did in Japan and be very difficult, given inflation inertia, to reverse.”

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Charles Evans, president of the Federal Reserve Bank of Chicago.Credit...Tim Boyle/Bloomberg News

Mr. Clarida also noted that “bank lending, much of it to small and medium-sized enterprises, has collapsed to an extent unprecedented in previous business cycles and continues to decline more than a year into recovery.” Such a credit crisis makes it particularly difficult for the Fed to stimulate demand by manipulating interest rates, he said.

Another paper, by Jeffrey C. Fuhrer, Giovanni P. Olivei and Geoffrey M. B. Tootell of the Boston Fed, noted that it was common for inflation to fall after a recession and concluded that “modest additional declines in inflation are likely.”

James D. Hamilton of the University of California, San Diego, argued in another paper here that trying to increase inflation expectations as a response to the crisis — through price-level targeting, for instance — was far easier in theory than in practice.

However, Mr. Hamilton did find reason to be hopeful. His research found that the Fed could lower long-term interest rates by selling short-term Treasury securities and buying longer-term securities. He also found that quantitative easing — the strategy of buying long-term assets to lower long-term rates — could be similarly effective.

Fear of deflation has loomed before. In 2003, as the economy recovered from the mild recession of 2001, Fed policy makers warned that further disinflation, or a slowdown in inflation, would be “unwelcome.” Mr. Bernanke called the moment “something of a watershed,” because “central banks, for the first time in decades, had to take seriously the possibility that inflation can be too low as well as too high.”

To prop up the economy the Fed bought $1.7 trillion in mortgage-backed securities and government debt last year and earlier this year. It is now considering resuming debt purchases, partly to stave off deflation.

Mr. Hamilton expressed hope for quantitative easing but said it might require creating huge sums of money. “If hundreds of billions are not enough to make much difference, then perhaps purchases in the trillions, such as the Fed has embarked upon with its holdings of mortgage-backed securities, might do the trick,” he wrote.

That argument seemed to find support from Kazuo Ueda, an economist at the University of Tokyo, who said that the Bank of Japan’s continuing fight against deflation might have been more effective had the central bank bought Japanese government bonds “on a much larger scale” than it has.

A version of this article appears in print on  , Section B, Page 3 of the New York edition with the headline: A New Quandary for the Federal Reserve: Grappling With Low Inflation. Order Reprints | Today’s Paper | Subscribe

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