James Bullard, president of the Federal Reserve Bank of St. Louis, said that inflation was sometimes seen as a way to "partially default" on existing debts, because it lowers the amount the borrower repays in real, inflation-adjusted terms.
"A partial default today through higher inflation would be paid for via higher inflation premiums in future borrowing. Creditors would want to protect themselves against an unpredictable central bank," he told the Economic Club of Memphis in prepared remarks. "Alas, in economics there is no free lunch," he said, quoting Nobel Prize-winning economist Milton Friedman.
Bullard is not a voting member of the Fed's policy-setting committee this year, but will hold a rotating vote in 2013.
"Is this happening? Distant inflation expectations from the TIPS (Treasury inflation protected securities) market seem to suggest that investors do not completely trust the Fed to deliver on its 2 percent inflation target," he said.
The U.S. has been slowly recovering from the deep 2007-2009 recession, which was caused by a collapse of the housing market that triggered a devastating global financial crisis.
Many U.S. households were left owing more on their homes than the properties were worth. At the same time, the U.S. government has aggressively expanded spending to shield the country from an even deeper downturn, widening the deficit and driving up national debt.
Bullard has publicly stated that he would not have voted for the Fed's third round of so-called quantitative easing announced at its policy meeting last month, at which it also committed to holding interest rates near zero until at least mid-2015.
The Fed also promised that it would keep rates ultra-low even as the economy strengthens, in order to ensure that stubbornly high U.S. unemployment was brought back to more normal levels, so long as inflation remained under control.
Bullard said that any effort to inflate away the debt problem would impose severe costs on the people who had lent the money, or those who lived on fixed incomes.
"The partial default would occur against savers, mostly older U.S. households, and against foreign creditors," he said.
Fed critics say that its $2.3 trillion purchases of Treasuries and mortgage-backed bonds, plus September's decision to buy another $40 billion of mortgage-backed securities every month until hiring picks up, will severely sap the value of the dollar.
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