Fed policy in the rearview mirror. Revisiting Bullard’s ‘Seven Faces of the Peril’
St Louis Fed President wrote ‘Seven Faces of “The Peril”’ three years ago in 2010. The peril he describes is an undesirable “steady state” with rates near the zero lower bound combined with low to negative inflation. “This new long run outcome can involve deflation and a very low level of nominal interest rates. Worse, there is presently an important economy that appears to be stuck in exactly this situation: Japan.” Clearly, the concern that this paper was meant to address was the risk that the US could fall into just such a quagmire. It’s close. Here we are three years later with low nominal rates, Core PCE price change of only 1.2%, and subpar growth.
http://research.stlouisfed.org/econ/bullard/pdf/SevenFacesFinalJul28.pdf
“In his criticism of the approaches and support of Keynesians to economic policy, [Milton] Friedman distinguished between three forms of lags which appeared in economic policy: the observation lag, the decision lag and the effect lag. He argued that these lags had major destabilizing effects and the challenge should be to simplify monetary policy to achieve stable growth in supply.” http://www.bized.co.uk/notes/2013/06/milton-friedman-and-his-contribution-economics
Not only do we currently have lags, it’s becoming increasingly murky as to what the policy decision should be. In any case, one of the problems Bullard identifies with the “unintended steady state” is that monetary policy becomes passive. He says that “…pledging to keep the policy rate near zero for such a long time would be consistent with the low nominal interest rate steady state in which inflation does not return to target but instead both actual and expected inflation turn negative and remain there.” To this point, I would say that the last FOMC non-taper decision further cemented expectations of low inflation.
In his paper Bullard outlines the seven arguments that address the problem of steady state low nominal rates and low to negative inflation. Topics that are not mentioned, and which very likely reinforce the peril are 1) huge debt levels relative to GDP 2) huge unfunded pension liabilities and 3) demographics that accentuate medical and retirement costs.
He concludes “that promises to keep the policy rate near zero may be increasing the risk of falling into the unintended steady state….and that an appropriate quantitative easing policy offers the best hope for avoiding such an outcome.”
Yesterday, NY Fed chief Dudley said that policy under Yellen would be the same as in the past. I don’t agree with Obama on much, but in some sense I understand his frustration when he said of Bernanke, “He’s already stayed a lot longer than he wanted or he was supposed to.” Fed policies appear stale with regard to improving underlying economic fundamentals. Perhaps Obama was (finally) right about pushing for a change in tack at the Fed and not wanting a career bureaucrat like Yellen at the helm. But he misplayed that hand.
Keep in mind that Japan has now embarked on several of the ideas in Bullard’s paper…including massive QE. Yet, JGB yield is only 66 bps today. It’s not clear that inflation/growth have hit escape velocity. One of the seven ideas to combat the steady state is as follows… “The gov’t threatens to behave unreasonably if the private sector holds expectations (such as expectations of very low inflation) that the gov’t does not desire. This threat, if it is credible, eliminates the undesirable equilibrium.” Here again, Japan has tried that strategy without success. In the US on the other hand, it can be argued that the gov’t has been completely credible in behaving unreasonably and irresponsibly, but in a way that more likely solidifies the unintended steady state.
Bullard writes, (again, from 2010), “During the recovery, the US economy is susceptible to negative shocks which may dampen inflation expectations. This could possibly push the economy into an unintended, low nominal interest rate steady state. Escape from such an outcome is problematic.”
It is now three years later. As Bullard suggested, the commitment to low rates hasn’t helped the US economy escape. However, neither has QE, though it has surely been a benefit at the margin. And even massive QE as being undertaken by Japan doesn’t seem to be doing the trick in an environment of aging population, and massive overhang of debt. In fact, it seems that the servicing of debt and other obligations related to previous malinvestment, both by the private sector and by the public sector in terms of unsustainable pensions, etc, might be the biggest factor in terms of restraining the economy.
So, the question is, will the ‘new’ Fed try bolder experiments to shake the economy up? Will the Reverse Repo Facility figure into that plan (if there is one)? There is almost always a trial by fire for the new Fed Chair, and this time will be no different, even if current policies remain in place. Let’s hope it doesn’t resemble the scene in Hitchcock’s North by Northwest where Roger Thornhill (Cary Grant) completely disrupts the auction process.
http://www.youtube.com/watch?v=4bdfenrWYTs
