St. Louis Fed's Bullard Discusses Five Questions on U.S. Monetary Policy

November 06, 2015

ST. LOUIS – Federal Reserve Bank of St. Louis President James Bullard on Friday discussed “Five Questions on U.S. Monetary Policy” at the St. Louis Regional Chamber Financial Forum.

The questions are pertinent to the discussion of whether the Federal Open Market Committee (FOMC) should begin to increase the policy rate from near-zero levels. Bullard noted that at its September 2015 meeting, the FOMC did not make such a move, citing global factors. However, “In October, the Committee removed the key sentence citing global factors and suggested that the zero interest rate policy could be ended soon, depending on incoming data,” he said.

“The market-based probabilities of a near-term end to the zero interest rate policy have increased,” Bullard said, adding, “While any decision will be data dependent, as always, some key questions loom for the FOMC.”

Reduced Global Uncertainty

Bullard suggested the first of the five questions facing the FOMC is, “What are the chances of a hard landing in China?”

He noted that last summer concerns grew about China experiencing a severe drop in its economic growth. “The fear developed in financial markets during August 2015 that China might experience a hard landing; that is, a sharp fall in the growth rate to zero or lower,” he explained. “This, it was feared, might presage additional weakness in emerging markets, and eventually spill over to the U.S.”

However, Bullard pointed out that these concerns dissipated when China’s growth in the third quarter was reported at 6.8 percent and the International Monetary Fund did not meaningfully downgrade the outlook for China’s macroeconomy. In addition, he noted that volatility indexes suggest that the probability of a hard landing has returned to pre-August levels. “The probability of a hard landing in China is no higher today than it was earlier this year,” he concluded.

Improved U.S. Financial Conditions

Bullard said another question looming for the FOMC is, “Have U.S. financial market stress indicators worsened substantially?”

Regarding financial conditions in the U.S., Bullard noted that while the China scare drove up U.S. financial market volatility in August and September, this volatility has since abated. He pointed to the St. Louis Fed Financial Stress Index, which includes components such as volatility measures and interest rate spreads. “The St. Louis Fed Financial Stress Index does not show particularly high levels of stress currently,” he said, concluding, “Financial stress today in the U.S. is not particularly high compared to the last five years.”

Cumulative Progress in U.S. Labor Markets

Turning to the labor market, Bullard addressed the third key question, “Has the U.S. labor market returned to normal?”

Bullard said that the unemployment rate has fallen faster than the FOMC expected, and that nonfarm payroll employment has increased faster than anticipated. “The unemployment rate, at 5.1 percent in September, is within the Committee’s central tendency of the estimate of the longer-run rate,” he said.

Bullard noted that roughly 1 million more jobs have been added relative to private sector forecasts as of September 2012, the date of the launch of the FOMC’s third quantitative easing program (QE3). However, “Job creation is expected to slow going forward as the economy continues to normalize,” he noted, adding, “Even with job creation as low as 130,000 per month, the employment-to-population ratio would remain constant.”

Another metric for labor market performance is the level of the Federal Reserve Board staff’s labor market conditions index (LMCI), he said, noting that “its value is well above historical norms, indicating excellent labor market health.”

Overall, “U.S. labor markets have largely normalized,” Bullard said.

Inflation Once Oil Prices Stabilize

Turning to inflation, Bullard said the next question to be considered is, “What will the headline inflation rate be once the effects of the oil price shock dissipate?”

While headline inflation measured from one year ago is very low, Bullard pointed out that this is due in part to the large drop in oil prices that began in mid-2014. “The fall in oil prices has only a one-time influence on the year-over-year inflation rate,” he said.

Bullard then looked at what the inflation rate would be assuming that oil prices stabilize at the current level and that all other prices continue to increase at the same pace as they have so far in 2015. He said that under such a scenario, the headline consumer price index inflation rate at the end of 2016 would be more than 2 percent.

“Oil price stabilization likely implies headline inflation will return to 2 percent in the U.S.,” he concluded.

The Dollar and Global Policy Divergence

Bullard said the fifth question encompasses the value of the U.S. dollar: “Will the U.S. dollar continue to gain value against rival currencies?”

He noted that the dollar has been relatively strong and has appreciated on a trade-weighted basis since mid-2014. “This has generally been viewed as a drag on U.S. economic growth during 2015. A key question is whether the dollar will continue to strengthen over coming quarters or not,” he said.

He then explained that since “foreign exchange markets are forward-looking and foresee most or all systematic movements in economies, including predictable policy movements,” only unexpected developments could cause further sharp movements. He cited as an example how the European Central Bank’s quantitative easing (QE), a key unexpected event in 2014, drove the euro-dollar exchange rate during 2014.

Now, “everything else is already priced in, including expected ECB QE and expected Fed normalization,” he said. “This suggests that the best guess about future movements in this exchange rate are largely unpredictable, and that the best expectation of the future exchange rate is the current level.”

“Global policy divergence has already been priced into foreign exchange valuations,” he concluded.

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