WASHINGTON, D.C. – Federal Reserve Bank of St. Louis President James Bullard on Tuesday discussed “More on Three Challenges to Central Bank Orthodoxy” at the 57th annual meeting of the National Association for Business Economics (NABE).
During his presentation, Bullard said that U.S. monetary policy is at a crossroads because central bank orthodoxy is being challenged. He outlined his version of a “classic” or “orthodox” interpretation of current macroeconomic events along with three challenges to that interpretation, which relate to strict inflation targeting, low real interest rates and globalization.
The orthodox view emphasizes the cumulative success that has been achieved so far with respect to the Federal Open Market Committee’s (FOMC’s) goals for inflation and unemployment. “The Committee has arguably achieved its objectives as well today as it has at any time since 1960,” Bullard said. Despite that, Bullard noted, the FOMC’s policy settings remain at emergency levels.
“The orthodoxy suggests a prudent policy of returning policy settings to more normal levels gradually over time, providing plenty of monetary accommodation during the transition to guard against macroeconomic risks,” he said.
Bullard noted that all three challenges to the orthodoxy claim that some aspect of it is deficient in the current environment, and that “this time is different.” While the challenges are interesting, Bullard said they fall short of providing a reliable guide for U.S. monetary policy.
Strict Inflation Targeting
The first challenge, which he called “strict inflation targeting,” suggests that labor markets have been overemphasized. In particular, it suggests: 1) the Phillips curve relationships have broken down completely or are badly damaged, or 2) all the information needed from the Phillips curve can be read off of actual inflation outcomes. “Either way, this challenge puts much less weight on labor market outcomes relative to the orthodox view,” Bullard said. According to this view, he noted, inflation is the only variable the FOMC needs to consider when setting monetary policy.
“An important drawback to the strict inflation targeting view is that it cannot easily justify the current policy of a zero interest rate,” Bullard argued, noting that the current inflation gap is too small to rationalize a zero policy rate based on low inflation alone.
“Strict inflation targeting may provide a reason to set the policy rate below its long-run level, but not all the way to zero,” Bullard said.
Low Real Interest Rates
The next challenge relates to the notion that real interest rates on short-term government debt and related securities are exceptionally low globally. Thus, the second challenge to central bank orthodoxy is to emphasize the implications of very low and time-varying real rates. He explained that this challenge suggests that monetary policy is actually not very accommodative today, and therefore, the zero interest rate policy (ZIRP) may remain appropriate.
“This challenge to orthodoxy, like others, is interesting,” Bullard said, “but it is unlikely that the current ZIRP can be rationalized by an appeal to low real interest rates alone,” he added. “By some measures, the traditional assumption of a constant short-term real rate equal to 2 percent is about right in today’s environment,” he said.
The third challenge that Bullard discussed suggests that because of increasing globalization, foreign economic developments need to be taken into account, separately and distinctly, in U.S. monetary policy deliberations.
However, Bullard noted literature on global monetary policy that suggests that if each policymaker pursues an appropriate domestically oriented monetary policy, the global allocation of resources will be optimal, or close to optimal. This implies that the domestic policymaker does not need to react separately and distinctly to foreign output or foreign inflation gaps. Furthermore, Bullard noted that this result does not depend on the degree of globalization.
Bullard said these three challenges to central bank orthodoxy ultimately do not provide sufficiently robust arguments to guide current U.S. monetary policy, and that the orthodoxy remains the best basis for near- and medium-term monetary policy decision-making.
“The orthodoxy argues for normalization of U.S. monetary policy based on cumulative progress toward Committee goals,” Bullard noted. He emphasized that policy will remain exceptionally accommodative even as normalization proceeds, given that policy settings are far from anything that could be called restrictive. “This continued accommodation will provide plenty of insurance against any remaining risks to the U.S. economy, and simultaneously it will mitigate against the dangers of maintaining extreme policy settings in an environment where conventional gaps have essentially narrowed to zero,” Bullard said.