OWENSBORO, Ky. – Federal Reserve Bank of St. Louis President James Bullard discussed “Fed Goals and the Policy Stance” at a Greater Owensboro Chamber of Commerce event on Thursday.
To achieve its mandates of price stability and maximum sustainable employment, the Federal Open Market Committee (FOMC) has been using two main tools for implementing monetary policy: the short-term policy interest rate, which includes forward guidance, and quantitative easing. “The U.S. economy is approaching normal conditions in terms of the main macroeconomic goals assigned to the Federal Reserve,” Bullard said. “However, the policy stance of the FOMC has not begun to normalize yet.” Noting that it will take a long time to normalize monetary policy, he added, “If macroeconomic conditions continue to improve at the current pace, the normalization process may need to begin sooner rather than later.”
While this mismatch between our macroeconomic goals and the stance of monetary policy is not currently causing problems for the economy, Bullard said it may cause problems going forward. “The objective is to execute policy normalization over the next few years without creating excessive inflation or substantial financial stability risks,” he explained.
Inflation and Unemployment
Bullard noted that while inflation has been surprisingly low from the second quarter of 2013 through the first quarter of 2014, recent readings on inflation have moved closer to the FOMC’s target of 2 percent.
On the labor market front, Bullard said that while U.S. unemployment has been high over the past five years, it is now much closer to normal. The unemployment rate today is about 1.4 percentage points lower than it was a year ago and only 0.3 percentage points above the median unemployment rate over the period from January 1960 to June 2014, he said.
However, he added that a smaller fraction of the U.S. population is participating in the labor market than during the 1980s and 1990s. “I interpret lower labor force participation as a relatively benign development driven mostly by demographics, and I project that labor force participation may decline further in the years ahead,” Bullard said.
He examined various projections that suggest that U.S. labor force participation is unlikely to rise on a sustained basis in the years ahead. “This suggests we should not expect an influx of workers coming back into the labor force, driving unemployment higher or slowing declines in unemployment,” he said. “Instead, unemployment is likely to continue declining so long as the economy remains relatively robust.”1
He further noted that hours worked might be a better way to think about the amount of labor being supplied to market work. “The index of aggregate hours worked has fully recovered to its pre-recession peak and seems poised to go higher,” he said, adding, “This view of the labor market also helps address the issue of part-time versus full-time jobs.”
To measure the distance of the economy from the FOMC’s goals, Bullard used a simple function that depends on the distance of inflation from the FOMC’s long-run target and on the distance of the unemployment rate from its long-run average. This version puts equal weight on inflation and unemployment and is sometimes used to evaluate various policy options, Bullard explained.
In his calculations, the target rate of inflation was set at 2 percent, the FOMC’s inflation target. The long-run average rate of unemployment was set at 5.35 percent, the midpoint of the central tendency of the FOMC’s Summary of Economic Projections in June. The function currently shows a low value that is close to pre-crisis levels, he said, adding that “the FOMC is closer to its macroeconomic targets today than it has been most of the time since 1960.”
Monetary Policy Stance
Bullard then discussed how close the FOMC’s monetary policy settings are to normal. In response to the financial crisis, the FOMC lowered the policy rate to zero and implemented outright asset purchases. While the FOMC began tapering the pace of asset purchases in January 2014, Bullard noted that the two main policy actions have not been reversed so far. That is, the Fed balance sheet is still large and increasing, and the policy rate remains at the zero lower bound.
Bullard measured the distance of the monetary policy stance from normal using a simple function that depends on the distance of the policy rate from its normal level and on the distance of the size of the Fed balance sheet relative to GDP from its long-run average. This version puts equal weight on the policy rate and the balance sheet, he noted.
In these calculations, the normal level of the policy rate was set at 5.5 percent, the average value of the federal funds rate from January 1975 to March 2014. The long-run average size of the Fed balance sheet as a percent of GDP was set at 7.4 percent, the average value over the same period. “Currently, the function measuring the distance of the policy stance from normal shows a high value, far from pre-crisis levels,” he said.
Thus, there is a mismatch. “The macroeconomic goals of the Committee are close to being met. However, the policy settings of the Committee are far from normal,” Bullard said. “While this mismatch is not causing macroeconomic problems today, it takes a long time to normalize policy and the mismatch may cause problems in the years ahead as the economy continues to expand.”
Normalizing Monetary Policy
Bullard discussed some factors that are mitigating the mismatch and why the FOMC has not begun normalizing policy. These factors have included a surprisingly low inflation rate for much of the past year, unexpectedly slow real GDP growth during most of the recovery and labor markets that do not seem to be fully recovered, although they are improving.
“Normalization will take a long time, and current policy settings are far from normal, suggesting an earlier start. Relatively low inflation and relatively weak labor markets have up to now suggested a later start,” Bullard said. “Stronger-than-expected data, rising inflation and rapidly improving labor markets may change this calculus in the months and quarters ahead.”
1 For more discussion, see Bullard’s speech on Feb. 19, 2014, “The Rise and Fall of Labor Force Participation in the U.S.”