Bullard on the Fed’s Dual Failure

Here’s James Bullard, President of the St. Louis Fed.

The Fed’s target is 2 per cent, so critics can say the Fed has not met this part of the mandate. When unemployment is above the natural rate, they say, inflation should be above the inflation target, not below.

I disagree. So does the economic literature. Here is my account of where we are: the US economy was hit by a large shock in 2008 and 2009. This lowered output and employment far below historical trend levels while reducing inflation substantially below 2 per cent. The question is: how do we expect these variables to return to their long-run or targeted values under monetary policy? That is, should the adjustment path be relatively smooth, or should we expect some overshooting?

So the U.S. was hit by a “large shock.”  And what kind of shock was this?  Bullard doesn’t say, but surely we can infer it was a demand shock.  After all, both prices and employment fell in late 2008 and early 2009, a supply shock would be inflationary.

Now the flaw in his argument becomes clear; Bullard is talking about demand shocks as if they are some sort of external shock, which has nothing to do with Fed policy.  In fact the Fed’s job, indeed its only important job, is precisely to control AD.

I’m sure that some will argue that the Fed isn’t able to offset demand shocks in the sort run.  That’s not true, as almost any severe drop in current NGDP will be associated with a large fall in future expected NGDP; one, two, and three years out into the future.  And of course that’s exactly what happened in late 2008, expectations of future NGDP plummeted, causing asset prices and current NGDP to plunge.  The Fed most certainly can control NGDP expectations one, two, and three years out.  Indeed when I presented a futures targeting paper at the New York Fed in the late 1980s, they basically said “Thanks, but not thanks, we can control inflation expectations just fine, without any help from the futures markets.”  And if the Fed had prevented NGDP expectations one, two, and three years out from plunging sharply, then current NGDP growth in late 2008 would have fallen much less sharply.

It’s now four years after the disastrous Fed policy of 2008, and the Fed is finally waking up to the fact that there’s a serious AD problem. Obviously if there is a serious AD problem today, then ipso facto the need for more AD was far greater back in late 2008 and early 2009. Make no mistake about it, the recent QE3 announcement was the Fed admitting that “we were wrong in late 2008 and early 2009, and the market monetarists were right.”  But Bullard still doesn’t recognize this reality.  He talks as if the US was hit by some sort of mysterious demand shock in late 2008, which was beyond the Fed’s control.  And he defends their refusal to quickly boost inflation and employment up to Fed targets by arguing that these problems need to sort themselves out naturally, at a measured pace:

Evidence, for example a 2007 paper by Frank Smets and Raf Wouters, suggests that it is reasonable to believe that output, employment and inflation will return to their long-run or targeted values slowly and steadily. In the jargon, we refer to this type of convergence as “monotonic”: a shock knocks the variables off their long-run values but they gradually return, without overshooting on the other side. Wild dynamics would be disconcerting.

I presume by “wild dynamics” he means a rapid fall in the unemployment rate with a modest and temporary overshoot of inflation.

Given this type of adjustment, it is clear the Fed could be “missing on both sides of its mandate” during the entire time it takes the economy to return to normal, even when the monetary policy is sound. In fact, missing on both sides of the mandate is exactly what one would expect under an appropriate monetary policy. Furthermore, the literature suggests that the adjustment times are quite long, possibly many years.

To argue against monotonic convergence now would imply that when unemployment is above the natural rate, monetary policy should aim for inflation above the Fed’s 2 per cent target. On the face of it, this does not make sense: the US has experienced periods when both inflation and unemployment have been above desirable levels. In the 1970s this phenomenon was labelled stagflation. Monetary policy has been regarded as poor during that period.

I’m not even going to respond to this argument.  If you can’t see the flaw, then you shouldn’t be reading this blog.

OK, OK, I’ll channel Milton Friedman:

To argue for monotonic convergence now would imply that when unemployment is above the natural rate, monetary policy should aim for inflation below the Fed’s 2 per cent target. On the face of it, this does not make sense: the US has experienced periods when both inflation and employment have been below desirable levels. In the 1930s this phenomenon was labelled “The Great Depression.”  Monetary policy has been regarded as poor during that period.

I can’t even imagine what Ben Bernanke thinks when he listened to his colleagues’ thought process as they make hugely consequential decisions that determine the fate of the world economy.

Lars Svensson was right; we need professors:

Monetary policy is a complicated area. Therefore, I think it is important that those who sit on the Executive Board has a good knowledge of macroeconomics, monetary policy and even financial stability – it may well be more professors of the Executive Board.

Bullard continues:

The financial crisis and the housing collapse probably did some permanent damage. The US growth rate is probably at about the potential growth rate given the situation, not far below as critics have suggested.

So now the problem is supply-side?  What happened to the great demand shock of 2008-09?  Did we recover from that?  If so, when?

If Bullard reads this I’m sure he’ll think I’m an arrogant, elitist jerk. And he’d be right.  I believe that only highly skilled monetary economists (people like Bernanke, Woodford, Svensson, McCallum, Taylor, Mishkin, Krugman, Mankiw, etc,) should serve on the Fed board. I also think the 7 member board should vote on monetary policy; the regional Fed banks play no useful role.  Bullard has some great personal qualities, such as being unusually open-minded for a policymaker.  He’s not an arrogant jerk like me; he’s willing to have conversations with bloggers.  So put him on the Supreme Court.  After all, if we have non-monetary economists determining monetary policy, why can’t we have non-lawyers evaluating legal matters?  I’m serious.