FRANKFURT, Germany – Federal Reserve Bank of St. Louis President James Bullard discussed “Permazero in Europe?” at the International Research Forum on Monetary Policy on Friday.
Bullard noted that the purpose of the Frankfurt conference is to promote the discussion of innovative research on issues relevant for monetary policy. “In this spirit, I will discuss some recent ‘neo-Fisherian’ ideas and what they might mean for the G-7 over the medium term,” he said. In particular, he examined the possibility of remaining at zero or near-zero policy rates over the medium term and the implications for monetary policy.
The Macroeconomic Equilibrium of 1984-2007
In the U.S., Bullard said that the key argument for monetary policy normalization is that while the goals of the Federal Open Market Committee (FOMC) have essentially been met, policy settings remain extreme. Regarding the FOMC’s goals, he noted that U.S. labor markets are close to normal and that inflation net of the oil price shock is reasonably close to the FOMC’s target rate of 2 percent. In contrast, the policy rate (currently at a target range of 0.25-0.50 percent) remains about 3 percentage points below the FOMC’s long-run level, and the Fed’s balance sheet remains more than $3.5 trillion larger than its pre-crisis level.
“Prudent policy suggests edging the policy rate and the balance sheet toward more normal levels,” Bullard said.
He noted that implicit in the argument for normalization in the U.S. is a desire to return to the macroeconomic equilibrium of 1984-2007. This period was characterized by relatively long economic expansions, relatively shallow recessions and relatively good monetary policy that was well understood by policymakers and financial markets.
“That equilibrium was associated with a higher nominal interest rate structure than we have today,” Bullard said, adding, “however, what if we cannot return to such a situation?”
He proceeded to examine the implications of this question, particularly given that the U.S. has been near the zero lower bound on the policy rate for the past several years and that the average short-term nominal interest rate among the G-7 countries is expected to be close to zero over the medium term. Furthermore, even if countries raise their policy rates from near zero, Bullard noted that negative shocks to the economy are always possible and have the potential to push short-term nominal interest rates back to the zero lower bound.
Permazero and Neo-Fisherian Ideas
“Zero interest rate policy (ZIRP) has usually been viewed as temporary and as part of a policy reaction to a very large macroeconomic shock. But ZIRP or near-ZIRP has been in place for seven years, far beyond the duration consistent with ordinary business cycle fluctuations,” Bullard said, adding, “arguably, this is an interest rate peg—a constant value of the policy rate independent of changes in macroeconomic conditions.”
He pointed out that many economists believe an interest rate peg is poor monetary policy, since trying to keep the short-term nominal interest rate unnaturally low could lead to instability in the form of very high inflation. However, he noted that overall inflation remains below target even after having ZIRP or near-ZIRP for seven years. “Perhaps inflation is still in the pipeline? Or, perhaps, is it time for a new model?”
To this end, he then explored the implications of neo-Fisherian ideas that include the core idea that an interest rate peg, in some circumstances, can be stable. In this context, “ZIRP, far from being a harbinger of runaway inflation, would instead dictate medium- and long-term inflation outcomes,” he said. (For additional discussion, see Bullard’s speech on Nov. 12, 2015, “Permazero.”)
Bullard said that the policy implications of these neo-Fisherian ideas are profound. “The continuing ZIRP in the G-7, far from putting dangerous upward pressure on inflation, may be leading us to an outcome with low nominal interest rates and low inflation that can last for a very long time,” he said. “This contrasts sharply with conventional wisdom and central bank rhetoric, including much of my own, which emphasizes that ZIRP is putting upward pressure on inflation and offers the best hope for returning inflation to target.”
To see how neo-Fisherian ideas match up with actual experience in the G-7 countries, Bullard examined the paths of the average short-term nominal interest rate and inflation rate in the G-7 countries since 2002. He noted that the average policy rate went to near zero following the Lehman-AIG event in September 2008, and is unlikely to deviate significantly from ZIRP over the medium term. Regarding G-7 inflation, although it returned to the 2 percent target after the financial crisis, it has declined about 3 percentage points since 2012.
“Developments in the G-7 since 2012 could be interpreted as neo-Fisherian effects taking hold,” Bullard said. In addition, he discussed how euro area data also point to a compelling neo-Fisherian story. “If ZIRP was sufficient to drive inflation back to target by 2012, why has continued ZIRP not kept inflation close to target or pushed it even higher?”
In conclusion, given the focus of the conference on issues that may be important for the medium- and long-term monetary policy outlook, Bullard said, “Neo-Fisherian ideas may have an important impact on our thinking about monetary policy in the future.”
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St. Louis Fed President and CEO
James Bullard is president and chief executive officer of the Federal Reserve Bank of St. Louis. In these roles, he participates in the Federal Open Market Committee (FOMC) and directs the activities of the Federal Reserve’s Eighth District.