Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.The FOMC is registering concern that the measured inflation rate is below its target, typically thought to be in the neighborhood of 2%. Of course the FOMC is careful to state this in terms of its dual mandate, as laid out in the Full Employment and Balanced Growth Act, otherwise known as the Humphrey-Hawkins Act. The Fed is supposed to care not only about inflation, but about real aggregate economic activity, as specified (somewhat vaguely) in the Act. I have always viewed the Phillips-curve language in the FOMC statement (language like "...substantial resource slack continuing to restrain cost pressures...") as the Fed attempting to have its cake and eat it too. If we accept that the Phillips curve is a structural relationship (of course a highly dubious notion, ever since Friedman wrote about it in the 1960s), then there is no conflict implicit in the Humphrey-Hawkins dual mandate. When there is resource slack we will then expect low inflation, and therefore both the inflation hawks and the Keynesians can be happy with a more accommodating monetary policy. If we're doubtful about the Phillips curve, we are going to have a harder time getting these two groups to agree.
The FOMC is signaling that it is concerned about the low level of inflation. They either hope that this will induce expectations of higher future inflation that will actually produce higher inflation today, or they are thinking that their previously announced policy of holding constant the size of the Fed's balance sheet as mortgage-backed securities (MBS) run off will produce results, or both. One policy they might have pursued is to actually increase the size of the Fed's balance sheet, perhaps by purchasing more long-term Treasury securities, as Jim Bullard seems to be considering here.
The actual change in policy, announced in the FOMC's August 10 statement was:
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1 The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.Now, it is not entirely clear why this matters. This is essentially the same as what would happen if the Fed exchanged MBS for long-term Treasury securities. What's actually happening is that some people are prepaying their mortgages and refinancing, so that a mortgage that was effectively on the balance sheet of the Fed is now on some private balance sheet, and the Fed is holding a Treasury security instead. Why should this matter? MBS on the Fed's balance sheet are effectively loans to the private sector; Treasury securities are loans to the Federal government which are going to be paid off with future taxes, so these are also effectively the liabilities of the private sector. What's the difference? It could be that the Treasury debt is not in fact backed by future taxes; maybe the private sector perceives that Treasury debt will just be rolled over by the Federal government, and some of it will be monetized. Then, we might think of the Fed's policy action as telling us to expect more future inflation, as MBS and Treasury securities are "backed" differently. The MBS were financed by issuing outside money that will be retired in the future, but Treasury securities are purchased with outside money that will be outstanding indefinitely, and will therefore be inflationary.
Of course, all of this depends on public perceptions about how outside money (currency and reserves) issued by the Fed is backed on the asset side of the Fed's balance sheet. But I think that most people are currently in the dark about what the Fed intends for the future. There is some clarification in the current FOMC statement - we know that the Fed thinks inflation is too low - but we have no information about, for example, what the Fed intends to do with the large stock of MBS it holds. Does it intend to let this run off due to prepayments, defaults, and natural maturing of the debt, or does it plan to sell these assets and, if so, at what rate? I think a clearer statement of intentions (even if contingent) would be helpful.