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Fed to Purchase Treasuries to No Avail Once Deflation Becomes Structurally Entrenched

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Federal Reserve Bank of St. Louis President James Bullard today said the central bank should resume buying Treasuries if the threat of deflation persists. In other words: quantitative easing, part 2. 

Everything is laid bare in a paper released today on the St. Louis Fed's Website with a title vaguely reminiscent of Nunnally Johnson or Hitchcockian psycho-drama, "Seven Face of 'The Peril'" Heh. At issue is the U.S. economy's descent into a Japanese-style deflationary outcome. The bizarre and contradictory nut of the thing is this:

(1) The FOMC's extended period language may be increasing the probability of a Japanese-style outcome for the U.S., and (2) on balance, the U.S. quantitative easing program o¤ers the best tool to avoid such an outcome.

One? Yes. Two? No.

Bullard is a voting member of the Fed and clearly disagrees with Chairman Ben Bernanke, who last week told Congress he believed the Fed could use "communication" to "plot the path of interest rates." Both men, however, believe firmly in the Fed's ability to control interest rates, a belief system which will be sorely tested as the deflationary debt unwind continues apace.

Interestingly, while he may share Bernanke's belief in the Fed's ability to manage the economy, Bullard is a bit more realistic on this point. In the paper he notes that quantitative easing did not work in Japan and was rather frank about the lack of policy tools the Fed has left beyond buying Treasuries.

The bottom line, as explained last week, is that the very presence of deflation in an economy managed by a central bank, which is the very definition of inflation, means the war has been lost. That's the main takeaway from this. The war is over. Now, all that's left are some final battles to be fought, in vain, as the deflationary debt unwind runs its course.

POSITION:  No positions in stocks mentioned.