Central View: Recent Monetary Policy and Inflation Expectations

James Bullard

In terms of monetary policy, attention often focuses on inflation and inflation expectations.  Although both have been increasing in the U.S. in recent months, the opposite was true a year ago.  Throughout the first half of 2010, various inflation measures experienced a disinflationary trend, meaning that the rate of inflation was decreasing but was still positive.

Amid concerns about inflation possibly falling below zero and with the federal funds target rate already near zero, Fed Chairman Ben Bernanke first discussed the possibility of additional quantitative easing in an August 2010 speech in Jackson Hole, Wyo.  The formal decision came in November 2010, when the Federal Open Market Committee (FOMC) announced it would purchase about $75 billion per month in Treasury securities through the second quarter of 2011. 

Given their forward-looking nature, financial markets had largely priced in the policy action following Bernanke’s August speech and before the November FOMC meeting.  Consequently, during that period, real interest rates declined, inflation expectations rose, the dollar depreciated and equity prices increased.  These financial markets effects of quantitative easing looked the same as if the FOMC had reduced the policy rate substantially in ordinary times, which shows that monetary policy can still be eased aggressively even when the policy rate is near zero. 

Financial conditions have continued to ease since the November decision.  In particular, the policy rate has remained near zero while expected inflation has continued to increase, meaning that real interest rates have continued to decline.  To the extent that expected inflation continues to rise, financial conditions continue to ease.

After the current quantitative easing program ends, it would be natural for the FOMC to put policy on hold.  This would mean keeping the policy rate near zero, leaving the “extended period” language in the FOMC statement and maintaining the Fed’s balance sheet at the same level it is at when the decision is made.  Going on hold would give the FOMC more time to assess the strength of the economy while continuing to monitor inflation and inflation expectations.

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