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The Federal Open Market Committee meeting next Tuesday promises to be the most interesting for about 12 months, since the outcome is far from certain. The recent slowdown in the US economy seems to have caused some members of the committee to soften their stance on monetary policy, and the markets have begun to speculate about a possible easing in policy. If this comes, it is likely to be very slight, since I doubt that the Fed has seen enough evidence yet to convince them that the economy is slowing in a dangerous way.
However, some members of the committee seem to be getting increasingly worried that the US may be about to fall into a deflationary trap, like the one which has affected Japan in the last decade. James Bullard, the president of the St Louis Fed, released a very interesting paper last week which analyses the Japanese precedent in some detail. Although he does not consider this the most likely development in the US, he does think that it is sufficiently probable to require contingency planning, in much the same way as the government might prepare for a terrorist attack which it hopes and expects will not happen.
I recommend anyone interested in monetary economics to read the Bullard paper in full. It is sophisticated (as one would expect from a former senior economist in the St Louis Fed), and it could become very important for Fed policy if deflation looms. However, it is fairly complex, and may need some interpretation for non specialist economists. Here is my attempt at an interpretation, which I hope does the argument justice. Please let me know if I have over-simplified or misinterpreted.
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