ST. LOUIS – Federal Reserve Bank of St. Louis President James Bullard discussed “A Tale of Two Narratives” on Tuesday during an event of the St. Louis Gateway Chapter of the National Association for Business Economics (NABE). In particular, he explained how the St. Louis Fed’s approach to near-term U.S. macroeconomic and monetary policy projections recently changed.1
Bullard noted that the St. Louis Fed’s previous narrative assumed that the economy is converging to a unique, long-run steady state and that values for key macroeconomic variables are essentially tending toward an average of their past values. With inflation and unemployment gaps near zero, he pointed out that business cycle dynamics appear to be over. Therefore, the implication under the old narrative is that “the policy rate would likely rise over the forecast horizon to be consistent with its steady state value.”
He then described how the St. Louis Fed’s new narrative differs from the previous one. “In the new narrative, the concept of a single, long-run steady state is abandoned. Instead, there is a set of possible regimes that the economy may visit,” he said. Bullard added that regimes are considered persistent and that switches between regimes, while possible, are not forecastable. In terms of monetary policy under this new narrative, the implication is that “the policy rate would likely remain essentially flat over the forecast horizon to remain consistent with the current regime.”
Bullard noted that the new approach delivers a simple forecast of U.S. macroeconomic outcomes over the next two and a half years. He indicated that the St. Louis Fed’s forecast is for real gross domestic product (GDP) growth of 2 percent, an unemployment rate of 4.7 percent and a Dallas Fed trimmed-mean personal consumption expenditures (PCE) inflation rate of 2 percent.
A regime-dependent policy rate path of 0.63 percent over the forecast horizon supports these forecasts for output, unemployment and inflation, he said, adding that “risks associated with this projected policy rate are likely to the upside.”
The Previous Narrative
Bullard said that during the past several years, the St. Louis Fed’s typical medium-term forecast was for output to grow at an above-trend pace, for unemployment to decline, for inflation (net of commodity price effects) to overshoot 2 percent, and for policy rate increases to be consistent with the unique steady state. He noted that from the second half of 2013 to the first half of 2015, output growth and unemployment data supported the previous narrative. However, inflation barely moved during that period.
Also, Bullard explained, output growth has arguably slowed and is currently not far from a 2 percent trend, unemployment may not fall much below current values, and trimmed-mean PCE inflation is close to 2 percent but not rising rapidly.
“The usefulness of our previous narrative may have come to an end,” he noted.
The New Narrative
Bullard said that the St. Louis Fed wanted to replace the certainty about where the economy is headed with a manageable expression of the uncertainty surrounding medium- and longer-term outcomes due to the different possible regimes the economy may visit.
As such, he discussed three important fundamental factors that determine the nature of the regimes: productivity growth, the real interest rate on short-term government debt and the state of the business cycle.
He noted that labor productivity growth has been low on average since at least 2011. Hence, this is viewed as a “low-productivity-growth regime.” Turning to the real rate of return on short-term government debt, Bullard noted that it has been exceptionally low by recent historical standards. This is viewed as a “low-real-rate regime.” Regarding the state of the business cycle, he said that “we have no reason to forecast a recession given the current state of the U.S. economy.” Therefore, this is viewed as a “no-recession regime.”
Because regime switches are not forecastable, he reiterated, the St. Louis Fed’s forecast is limited to a horizon of two and a half years, as the new approach does not include long-run projections.
He acknowledged that there are some risks to this forecast, including the fact that these fundamental factors could switch into new regimes. That is, the economy could switch to a high-productivity-growth regime, to a high-real-rate regime or to a recession state.
However, he concluded, “if a regime switch does occur, the policy rate path would have to change appropriately—it is still data dependent.”
1 For more details, see Bullard’s speech in London on June 30, “A New Characterization of the U.S. Macroeconomic and Monetary Policy Outlook,” and the St. Louis Fed’s statement released on June 17, “The St. Louis Fed's New Characterization of the Outlook for the U.S. Economy.”