Bullard: Japan's Experience Should Have Guided U.S.

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The U.S. should have looked at Japan's experience with near-zero rates before the December 2008 Federal Open Market Committee decision to drop rates near zero, Federal Reserve Bank of St. Louis President James Bullard said Thursday.

"The debate over the wisdom of locking in near-zero rates did not take sufficient account of the experience in Japan, in my view," Bullard said in remarks to the University of Arkansas, according to a release from the Fed. The Bank of Japan cut its policy rate to near zero in the 1990s and short-term rates in Japan remain at zero today.

The thinking here was the sooner rates hit zero, the quicker the economy would rebound and rates could go back up. "I have seen no evidence that this is true during the last five years," he said. "Instead, I think the December 2008 FOMC decision unwittingly committed the U.S. to an extremely long period at the zero lower bound similar to the situation in Japan, with unknown consequences for the macroeconomy."

While the financial crisis began in 2007, it wasn't until the September 2008 collapse of Lehman Brothers and AIG that panic really set in. "The fact that the crisis had been continuing for a year without turmoil in financial markets suggested more financial stability than actually existed in the system," Bullard said, noting that nothing suggested the catastrophic failures coming that fall.

In fact, he said, in August 2008 it seemed the U.S. had weathered the year-old crisis and slow growth was expected to continue. But, a "commodity price boom" slowed the economy further, which "greatly exacerbated the financial crisis and led to multiple financial firm failures."

The fed's cutting rates from September 2007 through March 2008 "was not as good a tonic for the situation as might have been hoped," Bullard said. While "lower interest rates cure all" is widely believed, "the rate cuts of early 2008 evidently did little to prevent the financial panic, and may have exacerbated the situation to some degree," he said, including sparking the commodity price boom.

Crude oil prices doubled in 10 months from 2007 through mid-2008, which slowed the U.S. economy in the last half of 2008, Bullard noted. "The lower interest rates the Fed engineered seemingly encouraged this activity, as firms borrowed cheaply and attempted to profit in commodities."

"As of early August 2008, the growth picture for the U.S. economy according to available real-time data was relatively good," he noted. GDP projections called for modest growth, and by mid-2008 a case could be made that the economy would "muddle through" the year, except for a spike in oil prices, which damped the economy.

"Forecasters started to realize that the economy was slowing more appreciably than had been expected," Bullard said.  "The slower economic growth made the financial crisis much worse."

Bear Stearns' failure, and its purchase by J.P. Morgan, with fed assistance, suggested the four U.S. investment banks larger than Bear had the Fed protecting them from failure, he said. When market volatility decreased after the deal, "This success suggested that the Fed could buy time to allow the economy to get past the financial crisis by encouraging stronger firms to buy weaker firms in imminent danger of failure," Bullard said. "This 'marriage model' might have worked, had there not been so many marriages to arrange," he added.

As for the failures of Lehman and AIG, Bullard said, "The Lehman failure by itself was not particularly surprising and the U.S. economy could have coped with this single event.

"What was relatively surprising was that AIG, one of only a handful of triple-A-rated firms in the U.S., was also in incredibly deep trouble," he added. That cast a pall over all financial firms and exacerbated the financial crisis from mid-September 2008 onward.

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