TOKYO — Federal Reserve Vice Chairman Janet Yellen said Thursday that a big reason why the Fed has acted so "aggressively" to stimulate the U.S. economy is to avoid the "corrosive and dangerous" effects of deflation.
But Yellen, speaking ahead of the annual meetings of the International Monetary Fund and World Bank, suggested that the Fed and other major central banks are near the limits of what they can do to offset weak private demand and the inability of debt-ridden governments to provide more fiscal stimulus.
Yellen has supported the Fed's three rounds of large-scale asset purchases or "quantitative easing," including the $40 billion per month QE3 launched last month. But she said there is a limit to how low long-term interest rates can go and questioned how much more "capacity" the Fed and other major central banks have.
She said the Fed drew heavily on Japan's experience with deflation as it approached the zero lower bound for the federal funds rate in wake of the mortgage crisis, as she participated in a panel discussion hosted by the Institute of International Finance.
Japan's experience has shown the "corrosive and dangerous impact of allowing deflation to take hold and become an expected way of life," Yellen said, adding that the Fed has applied those lessons "as we found ourselves with a severe shortfall of demand."
Yellen said she and her fellow Fed policymakers concluded that "the most important thing can do is to act aggressively... once interest rates have been brought down to zero" to avoid an excessive decline in inflation expectations. Otherwise, she said real interest rates would be "higher than we want them to be."
"We've tried to be quite aggressive and forward leaning... to stimulate the economy and not let inflation fall below the level that we've deemed desirable, which is 2%," she said, adding that the Fed does not want inflation to go "too low."
She declined to join Standard & Poor's chief global economist Paul Sheard's sharp criticism of the Bank of Japan for, in his view, being too timid with its quantitative easing. While the BOJ has increased its balance sheet by 35%, the Fed has increased its balance sheet by 210%, he noted.
Having said that central banks need to be "aggressive" in countering deflation, Yellen said there are limits to what they can do, including "limits to how low long-term rates can go."
For the BOJ, she said, the task of defeating deflation is tough, because "you've already used most of the tools you have.... The credibility of establishing the central bank's ability to use that would be very challenging."
Speaking of central banks more broadly, Yellen said "at this point we have a global shortage of aggregate demand," and that presents monetary policymakers with "a dilemma."
"I don't think it's possible for decoupling (among economies) to occur," she said. "When you look at what's going to be necessary in the U.S. and Europe" in terms of "the need to have fiscal consolidation and the fact that monetary policy in most advanced economies has its foot on the accelerator and is doing virtually all it can to compensate for weak private demand and fiscal consolidation, the scope for (monetary) policy to stimulate" the economy in the U.S. and Europe "it's not obvious that there exists that capacity."
So, without mentioning its name, Yellen concluded that countries like China need to do more to boost global growth.
"It seems to me that if the global economy is to grow in line with its potential. Those countries that have the capacity to stimulate demand need to take steps to do so."
She acknowledged that China has said it wants to do that, but said the question is over what timeframe.
Another participant in the panel was Masamichi Kono, vice commissioner of Japan's Financial Services Agency and chairman of the International Organization of Securities Commissions.
Kono said he has become concerned that, in trying to more tightly regulate banks in wake of the financial crisis, governments may be going too far and making them too cautious about providing credit to the economy.
He singled out Europe, where he said a "very clear and significant deleveraging of banks" is hurting growth.
Regulators have taken steps to suppress "bad securitization" of loans, but in the process could "suppress good securitization," Kono warned, adding that better balance needs to be struck.
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