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James Bullard: U.S. Economy and Monetary Policy
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On Thursday, April 21, James Bullard joined Markus' Academy for a lecture on U.S. Economy and Monetary Policy.
During a presentation at Princeton University, St. Louis Fed President Jim Bullard presented two interpretations of whether the Federal Reserve is “behind the curve” on raising its policy rate relative to high inflation.
Bullard said that U.S. inflation is exceptionally high and comparable to inflation in 1974 and 1983. Standard Taylor-type monetary policy rules, even if based on a minimum interpretation of the persistent component of inflation, still recommend substantial increases in the policy rate, he said. This provides one definition of “behind the curve,” and the Fed is far behind based on this definition, he noted.
“However, all is not lost. Modern central banks are more credible than their 1970s counterparts and use forward guidance,” he said. “Credible forward guidance means market interest rates have increased substantially in advance of tangible Fed action. This provides another definition of ‘behind the curve,’ and the Fed is not as far behind based on this definition.”
Here are the highlights from Bullard's lecture:
[0:00] Introductory Remarks. This webinar continues our focus on inflation and connects to a number of previous “inflation webinars.” Timing of monetary policy has to factor in that interest rate moves impact the real economy only with a delay (an aspect which the 2020 Fed Framework underemphasizes), while on the other hand asset prices already anticipate future interest rate steps and with it the impact on the real economy. Acting swiftly requires ultimately fewer interest rate moves - consistent with the saying “a stitch in time saves nine” - and hence might make a soft landing in GDP more likely. However, central banks might shy away from early action, as such an interest rate move might trigger some financial markets disruptions - a phenomenon related to “Financial Dominance.”
[15:35] U.S. inflation is high, comparable to that in 1974 and 1983. The committee uses the Core PCE inflation because some have thought it to be a broader measure of underlying inflation. In 1974, FOMC kept the policy rate, and real interest rates low, which meant there was nearly a decade of higher inflation, and a volatile real economy, even though the FOMC believed it would drop. In 1983, the FOMC took an active role, keeping the policy rate higher and stabilizing the economy, leading to an idea that you must avoid getting “behind the curve”.
[26:37] Standard Taylor-Type monetary policy suggests the Fed is way behind the curve. The Fed aims for a 2% inflation target, yet Headline PCE inflation was 6.4% in February, with core inflation at 5.4%, though the Dallas Fed trimmed mean rate is only 3.6%-- a core inflation measure which should better account for factors like the global inflation surprise and the war in Ukraine. Using the 3.6% percent figure, this gives a “minimal” definition of “behind the curve,” though it will not include food or energy. A Taylor-type calculation using generous values, suggesting a lower policy rate than some would estimate, suggests that the policy rate is 300 basis points too low, and that we need a 3.5% policy rate. Sudden moves could be dangerous, however, and are perhaps avoidable.
[40:27] Credible forward guidance suggests that the Fed is not as far behind the curve. Central banks are more credible than in the 1970s, which means that forward guidance can play a key factor in current market pricing, and help fight this challenge. Although the policy rate has not moved, forward guidance has led to an increase in the short term treasury yield and the 30-year fixed mortgage rate, suggesting that Fed credibility in forward guidance plays a large role. Given that the 2-year Treasury yield is 2.46% (April 18, 2022), this would suggest the FOMC is only about 100 basis points under the 3.5% suggested by the Taylor rule– not terribly behind the curve. Followthrough is essential in maintaining credibility. Financial market conditions often include corporation specific factors including equity prices, which are volatile, meaning that they are not as helpful when determining policy rates.
[58:23] Risks to Inflation Expectations. The TIPS market suggests that inflation expectations are rising: 5-years are at 3.36% (April 19, 2022), meaning that the spread between actual inflation and expected inflation will have to be resolved. Either Core PCE must come down, or there will be even higher inflation expectations, which could lead to a problem over the next decade or longer. The TIPS market is a good metric to emphasize, because of its sensitivity to current events, whereas survey measures are less sensitive.
[1:09:13] Key takeaways: Through forward guidance and the Fed’s credibility, as well as the abnormally high inflation due to exogenous shocks, the Fed is not actually as far behind the curve as it may initially seem. There still must be policy rate increases to justify the forward guidance given, maintaining credibility. Wage-price spirals are symptoms of inflation, not causes, so looking to the Central Bank is more important than the labor market. Some future actions surrounding the balance sheet runoff will still affect inflation rates and expectations, because the Fed does not have full credibility and perfect forward guidance.
Posted: April 21, 2022 Thursday 12:30 PM