A Member Of The Federal Reserve Has Delivered A Monster Slam On The Direction Of Fed Policy

A Singular Achievement of Recent Monetary Policy

Photo: St. Louis Fed

James Bullard, head of the Saint Louis Federal Reserve, is known for his hawkish stance on Federal Reserve policy, and he’s been an outspoken critic of additional monetary easing.That has put him at odds with the current course of policy, wherein the Fed recently announced open-ended easing until unemployment returns to pre-crisis levels.

But Bullard says it’s a futile attempt because unemployment simply can’t return to pre-crisis levels – a reflection of the argument that the economy is facing a “new normal” going forward.

In a whopper of a presentation delivered last night at the University of Notre Dame, Bullard explained why the Fed is wrong to try to stimulate more – and how the central bank could lose control of inflation before monetary policymakers even realise their mistake.

The Fed's best decision would have been to maintain the price leve on the established path when the crisis hit in 2008

Since the 2008 crisis, it's clear that GDP trend growth is much slower in the U.S. – much like growth after other financial crises

A popular argument – that the Fed should target a specified level of nominal GDP – wouldn't be as effective as current monetary policy, and could be an unmitigated disaster

Stresses in the financial system were extremely high in 2009, as evidenced by interest rates and volatility measures

Here is a chart displaying the shock the financial crisis caused to the system

A popular theory on monetary policy right now, advanced by Michael Woodford, is that good monetary policy helps to bring prices in line with changing supply and demand

Here is how price level targeting works

Here is a graph from Michael Woodford showing how price level targeting is supposed to work

The good advice from Michael Woodford's theories is that even when a large shock hits the economy, the current, established path of the price level should be maintained by monetary policy

The actualy price level right now is close to the established path of 2 per cent annual inflation in prices

This chart illustrates that the actual price level is following the path being targeted by monetary policy

So, it appears that the basic advice of Michael Woodford's theory has already been followed

This advice regarding monetary policy has already been fully implemented by policymakers

Japan is an example of an economy where the price level diverged substantially from the central bank's targeted path

When the central bank fails to reach its targets, it's therefore fairly obvious

Normally, using monetary policy to return the price level to its intended path after a shock is preferable

But in this case, the crisis was especially severe because all of the preceding economic growth was caused by an artificial housing bubble

The current trend in real GDP growth is lower than it was pre-crisis

The same is true for employment levels

Sweden used aggressive monetary policy to respond to a big shock in the 1990s, but employment still never rose to pre-crisis levels

Here is a chart showing Swedish employment before and after their crisis event

One component of U.S. nominal GDP – inflation – seems to be right on target, while the other component – real GDP – is much lower than before the 2008 financial crisis

Here is the chart Woodford uses to argue his point that the Fed should be more aggressive with monetary policy measures

The problem is that the argument for more stimulus, based on nominal GDP levels, doesn't account for the fact that real GDP is lower since the crisis

When the adjustment for lower real GDP is taken into account, nominal GDP seems to be tracking the expected path of growth

Thus, it appears that GDP growth and inflation are both where they should be expected to be

In the 1970s, a similar misunderstanding on the part of policymakers caused double-digit inflation

Other research shows that inflation could rise by 3% above what was intended before policymakers realise their mistakes

The U.S. experience seems to reinforce that maintaining a stable price level path has already been achieved

Thus, Nominal GDP targeting could be a monetary policy disaster

An ECB member gave a big presentation on ECB policy yesterday too:

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