Before discussing Jim Bullard's speech, I should reveal my connection to him. Here in St. Louis, we have an excellent working relationship between the economics department at Wash U and the research department at the St. Louis Fed. The relationship is mutually beneficial. Research is better at both institutions as a result. At the University, we can hire better people because those people know that they can interact with the economists at the Fed, and the Fed can hire better people than otherwise because those people know that they can have contact with Wash U. We have a joint seminar in macroeconomics that alternates between the Wash U campus and the Fed. A large number of people in our department have arrangements to do some work for the St. Louis Fed. This includes me. My work consists of visiting the St. Louis Fed about one day a week as a Research Fellow. I have an office there, and when I am at the Fed I talk to my colleagues there about research and other matters of concern to us (e.g. recruiting), I attend seminars and conferences, and I attend informal policy meetings at which Jim Bullard is present. Academics who visit the Fed do not attend formal policy meetings - e.g. briefings for FOMC meetings. We do not have security clearance for such meetings, are completely out of the loop on what transpires at those meetings, and we know nothing of what goes on at the FOMC meetings in D.C. Jim Bullard and I are friends. We have known each other for a long time through our interactions in the economics profession - at conferences principally. Until last year when my youngest son and Jim's daughter were graduating seniors at Clayton High School (and in some of the same classes), we were also Clayton High School parents, and we would see each other frequently at school events.
Thus, this is something of an inside job, but trust me. I'm going to be objective. Jim has come into his own as a central banker since he took on the job as President of the St. Louis Fed. If you have ever seen him speak in public, you know that his grasp of policy issues is excellent, as are his communication skills. Jim can stand up in front of a sizable audience, speak extemporaneously about current policy issues, and make perfect sense, to high-end economists and lay people alike. His foot always stays out of his mouth, even with press people in the room (who can be fond of taking remarks out of context). He is relaxed, has first-rate people skills, and does a lot to inspire confidence in the institution.
This is a well-crafted work. There is plenty of language in there that will help to make the ideas comprehensible to a lay person, and the ideas are important. The basic ideas in Jim's speech are as follows.
The Fed has adopted flexible inflation targeting. What this means is that the target for the annual rate of increase in the raw pce deflator is 2%, but the Fed is willing to shade the target up or down, depending on the "output gap." If real GDP is deemed to be too low, the inflation target should be higher than 2%, and if real GDP is deemed to be too high, the inflation target should be lower. The idea here is often formulated in terms of a "Taylor rule," which specifies how the Fed's policy interest rate should react to inflation and the output gap. The FOMC certainly does not specify an explicit rule, but some macroeconomists have argued that the Fed's historical behavior conforms to it.
There is a problem with flexible inflation targeting and Taylor rules. We cannot measure the output gap directly. To measure the gap we need a model. New Keynesians have a well-defined notion of what the output gap is. In a New Keynesian model with sticky prices and/or wages, there is an inefficiency due to relative price distortions. Efficient output is the level of aggregate GDP that would have been achieved if prices and wages were perfectly flexible, everything else held constant. Thus, the output gap arises in a New Keynesian world because of sticky price and/or wage distortions. Not everyone is convinced that this stickiness matters that much in general, or matters that much now. According to the NBER, the last recession in the United States began in December 2007. So, if stickiness were an important factor in propagating the shock or shocks that caused the recession out to the current date, prices and wages would have to be VERY sticky. So sticky, in fact, as to be inconsistent with what we observe in the Bils/Klenow data or in empirical work on New Keynesian models, as far as I can tell. More than four years have passed since the onset of the recession, for Pete's sake.
But maybe there is some other inefficiency that monetary policy can correct? Note the key subtlety here. The central bank needs to define the output gap not only in terms of inefficiency, but in terms of inefficiency that the central bank actually has some control over. What other sources of inefficiency have people suggested? Perhaps a key problem is some kind of "debt overhang?" Maybe people somehow accumulated an inefficient quantity of debt from, say, 2000 on? If the Fed can engineer a higher rate of inflation, then this deflates the debt and solves the problem. Of course, we then redistribute wealth from creditors to debtors. Maybe that is not such a great idea, as some of those creditors are our financial institutions, and the ultimate creditors are the banks' shareholders and depositors. I know there isn't a lot of sympathy for bankers these days, but after our financial crisis experience, we might actually be concerned about the health of our banks. But there are other ways to redistribute wealth. The obvious solution is fiscal policy, which is far more flexible in redistributing wealth than monetary policy will ever be.
Now, it's hard to think of anything else in terms of central-bank-correctible inefficiencies that might exist in the current circumstances. Some people seem to think that the Fed's purchases of mortgage-backed securities somehow corrected a problem in the mortgage market. But one could argue that this simply postponed the adjustment that needed to be made in housing and mortgage markets, and represented a dangerous precedent in terms of the engineering of credit allocation by the Fed.
But, suppose we look at the time series of real GDP for the US, as shown in the chart (actually the natural log). That picture is quite striking. Real GDP is not bouncing back from this recession as has typically happened in the post-World War II time series. Real GDP in the US grows on trend at about 3% per year. Look in the 4th edition of my intermediate macro book, page 6. That chart shows the natural log of per capita real GDP from 1900. The striking thing about the picture is how closely the time series hugs a growth path of about 2% (i.e. about 1% average population growth and 3% average real GDP growth). Of course the Great Depression is different, but the economy is back on trend after World War II - it's as if the Depression and the War never happened, if you are just looking at the time series.
But look again at the chart above. Real GDP falls below the 3% trend in the last recession, then starts growing again, but it shows no sign of wanting to come back to trend. One possibility is that we're in something like the Great Depression, except on a smaller scale. Indeed, some people have taken to calling what we are experiencing the "Lesser Depression." But that doesn't seem right, just looking at the real GDP time series. Real GDP was actually growing at a rate greater than the long-run growth rate coming out of the trough of the Great Depression. The Great Depression lasts so long mainly because the Great Depression is so deep. Real GDP per capita drops by about 29% from 1929 to 1933, and it has to grow from 1933 for a long time above the trend rate of growth to get back to the trend growth path. Coming out of the most recent recession, real GDP growth has been relatively sluggish, and our last observation (for 4th quarter 2011) was 2.8% growth - about at the trend growth rate of 3%.
So, Jim Bullard explores the following idea. Perhaps the output gap is now essentially zero. Why? There was a negative wealth shock that produced a negative level effect on real GDP. We're not going to go back to the 3% real GDP growth path we were on before the recession; we're now on a lower 3% real GDP growth path. Obviously you can't say this is right or wrong, as you actually have to write down a model that's going to allow you to measure the effect. But I think the idea has merit, though perhaps you need to develop it further. Think of this as a collateral shock rather than a wealth shock - it's not quite the same thing. Under any circumstances part of the price of housing is a bubble, just like money is a bubble, for example. A house is not valued only because of the stream of future benefits it provides. It is also valued because the house serves as collateral for acquiring fungible mortgage debt. Further, that mortgage debt can be repackaged in mortgage-backed securities which also serve as collateral in financial arrangments - shadow banking for example. In fact, through the process of rehypothecation, those mortgage-backed securities can be used at any given time to support multiple credit arrangements. Thus, a given house, through a kind of multiplier effect, can support a large quantity of credit, both at the consumer level, and in sophisticated credit arrangements among large financial institutions. This all feeds back to the price of the house, potentially making the bubble component of housing prices quite large.
There is nothing wrong with such a bubble in housing. Indeed, the bubble just reflects the usefulness of real estate as collateral. The problem is when you have a major lax-regulation-driven incentive problem like the one that developed post-2000. Then, part of the housing bubble is built on false pretenses, and when people ultimately catch on to what is going on, the bubble pops. I.e. 2006. So, the reason why we now have a zero output gap could be that we have lost the false-pretense part of the housing bubble. But this also implies that something else is going on. You see, with the false-pretense housing bubble we were hugging the 3% growth trend, or maybe a little worse. So maybe from 2000 on, average growth without the false-pretense bubble would have been poor relative to historical standards. That's not good news at all.
A second view, more optimistic, comes from the employment report on Friday of last week. Combine this with Bullard's ideas, and maybe we get something a little better ultimately. Possibly the false-pretense bubble isn't as large as it might appear right now from the chart above.
The third view is from Paul Krugman's Monday NYT column. I'm going to be a little half-hearted about this, as I've come to the conclusion that the guy isn't really worth the time I spend on him (and about time you might say). Whatever that Krugman condition was that I had, I may have actually worked through it. Krugman is a has-been academic economist and a schlock journalist, who now appears to get all his information from low-level blogs, and is out of touch with serious current economic research. Nobody is going to learn anything from him anymore, sad to say. What a waste of a fine mind.
But, you might say, Krugman is so good at forecasting the future. I have never seen Krugman issue a proper forecast - one that has numbers in it. Did I ever tell you that I can forecast? I actually did it for a living once, when I was 24. I could out-forecast Krugman any day. But even if Krugman could forecast, why would we care? A really good forecaster is Laurence Meyer, whose forecasting company is in my home town, Clayton Missouri. Meyer actually has Fed experience, but I wouldn't trust him to do monetary policy if my life depended on it. He knows less about state-of-the-art macroeconomics than Krugman does.
In Krugman's column, let's focus on just a couple of things. First:
What’s the reasoning behind those demands [for tighter monetary policy]? Well, it keeps changing. Sometimes it’s about the alleged risk of inflation: every uptick in consumer prices has been met with calls for tighter money now now now. And the inflation hawks at the Fed and elsewhere seem undeterred either by the way the predicted explosion of inflation keeps not happening, or by the disastrous results last April when the European Central Bank actually did raise rates, helping to set off the current European crisis.I don't hear any strong hue and cry for tighter monetary policy right now. If the so-called inflation hawks on the FOMC felt strongly that we need tighter policy, they would have dissented at the December 2011 FOMC meeting. But they didn't. Indeed, Kocherlakota, Plosser, and Fisher voted for the action (essentially unchanged policy from the previous meeting), but Evans voted against it, as he wanted more accommodation. Thus, the committee was essentially with Krugman, and on net is dovish, not hawkish. Get your facts straight, Krugman. Of course, we know what happened in January. The Fed made an extremely risky, accommodative move. They were with Krugman again. What does he want?
And every time we get a bit of good news, the purge-and-liquidate types pop up, saying that it’s time to stop focusing on job creation.Read Jim Bullard's speech. The speech was given last Monday, and the jobs report came out the previous Friday. There is nothing in the speech about the jobs report. Clearly Jim Bullard's speech is about a broader issue and not about one month's information. I think Krugman never read the speech, and he guessed that it was a response to the employment report. Sloppy work, but he's willing to bad-mouth a Federal Reserve Bank President based on guesswork, in the pages of the New York Times.
Sure enough, no sooner were the new numbers out than James Bullard, the president of the St. Louis Fed, declared that the new numbers make further Fed action to promote growth unnecessary. And the sad truth is that the good jobs numbers have definitely made it less likely that the Fed will take the expansionary action it should.
Here's what I'll do henceforth. Krugman commentary will be restricted to the following:
1. Krugman actually says something useful.
2. Krugman attempts to discredit someone I care about in a dishonest way.
3. Krugman says something nasty about me. Then I fight back.
Let's go do some economics.
Bottom line here, on the "three views" issue. I think Bullard's argument has merit. If so, the FOMC decision at the January meeting - i.e. forward guidance of a near-zero policy rate out to the end of 2014 - could be a policy mistake of monumental proportions. More on that later.