St. Louis Fed's Bullard Discusses Two Monetary Policy Normalization Views

SANTA BARBARA, Calif. – Federal Reserve Bank of St. Louis President James Bullard discussed “Slow Normalization or No Normalization?” on Thursday during the 35th UC Santa Barbara Economic Forecast Project hosted by the University of California, Santa Barbara.

Bullard noted that recent U.S. monetary policy discussions have been dominated by issues related to the possible pace of increase in the Federal Open Market Committee’s (FOMC) policy rate. He discussed two views regarding the expected policy rate path: the FOMC’s scenario and the market-based scenario.

“The FOMC has laid out, via the Summary of Economic Projections, a data-dependent ‘slow normalization,’ whereby the nominal policy rate would gradually rise over the next several years provided the economy evolves as expected,” he said. “Market-based forecasts of FOMC policy, in contrast, envision ‘almost no normalization,’ whereby the policy rate would be changed only a few times in the next several years.”

Bullard briefly compared and contrasted each view, starting first with the FOMC’s scenario.

The FOMC’s Scenario

He cited three factors in favor of the FOMC’s scenario: relatively strong U.S. labor markets, inflation measurements that are closer to the FOMC’s target of 2 percent, and waning international headwinds.

Strong U.S. Labor Markets

“U.S. labor markets are at or possibly well beyond reasonable conceptions of full employment,” he said. For example, he noted that job openings per available worker are at a cyclical low, unemployment insurance claims relative to the size of the labor force are at a multi-decade low, and nonfarm payroll employment growth has been impressive. In addition, the level of a labor market conditions index created by staff at the Board of Governors is well above historical averages.

“In short, labor markets are relatively tight,” he said.

U.S. Inflation Closer to Target

While inflation has been relatively low in the U.S. during the last several years, Bullard explained that large movements in oil prices have had a major impact on headline inflation. “Measures intended to give an indication of inflation movements net of oil price effects have been trending somewhat higher,” he said.

International Factors Waning

“International influences on the U.S. economy have been widely discussed in global financial markets during the last several years,” Bullard said. “Those factors appear to be waning during the first half of 2016.” In particular, he noted that financial stress has declined according to recent readings, and that the effects of a stronger dollar appear to be waning.

The Market-Based Scenario

Bullard then discussed two factors in favor of the market-based scenario: the slow growth of U.S. real gross domestic product (GDP) and low U.S. inflation expectations.

U.S. Real GDP Growth Below Trend

Bullard noted that real GDP growth has been slower than trend in recent quarters, with first-quarter real GDP growth at just 0.5 percent at an annual rate, according to the most recent estimate. This estimate may be influenced by the “residual seasonality” issue, he said, explaining that first-quarter real GDP has been low since 2009.

“Still, combining actual data from the second half of 2015, the first quarter of 2016, and tracking estimates for the current quarter, the suggestion is that the U.S. is growing below a trend pace of 2 percent,” he said.

Inflation Expectations Still Too Low

Looking at market-based measures of inflation expectations, Bullard noted that while they were relatively satisfactory during the summer of 2014, they fell with oil prices and renewed a downward trend beginning in late 2015. “Recently, market-based inflation expectations have recovered somewhat,” he said. “However, they remain low compared with the levels observed in the summer of 2014.”

To sum up, the FOMC median projection for the policy rate suggests a gradual pace of rate increases over the next several years, Bullard said. Meanwhile, the market-based expectation for the policy rate is much shallower, with only a few increases over the forecast horizon.

“Evidence from labor markets, inflation readings and global influences suggests the FOMC median projection may be more nearly correct,” he said. “Evidence from readings on GDP growth and market-based inflation expectations suggests the market view of the path of the policy rate may be more nearly correct.”