Dial “M” for Monetary Policy (speech by Pres. Bullard, StLouisFed)

New York Association for Business Economics
Harvard Club of New York
New York
Feb. 17, 2009

Four aspects of the current situation

According to the National Bureau of Economic Research, the U.S. economy has been in recession since December 2007. Real national income held up remarkably well through the first three quarters of this recession—especially given the ongoing financial turmoil. But real output contracted rapidly in the last quarter of 2008, declining 3.8 percent at an annual rate according to preliminary estimates. Payroll employment shrank continually throughout last year, and the decline in jobs accelerated rapidly in the fourth quarter and into January of this year. At this point it seems likely that output and employment will continue to shrink in the first half of 2009.

There are several important aspects to this contraction.

First, the ongoing financial turmoil has affected a broad spectrum of financial markets and institutions around the world. The initial turmoil was associated with the downturn in the U.S. housing market and the attendant increase in defaults on a variety of mortgage products.

Second, during the fall of 2008 and into early 2009, the Fed has injected an astonishing amount of liquidity into the economy. As a result, the U.S. monetary base has grown from $871 billion in August of last year to $1.73 trillion in January 2009.(1) This undertaking has supported domestic financial markets as well as domestic and international financial institutions.

Third, the current recession is a global phenomenon. Growth has slowed appreciably or turned negative in many industrial countries, including the euro area, the U.K. and Japan.

In my remarks today, I will lay out a three-part thesis that takes these facts as a starting point.

In the first component, I will argue that a key near-term risk for 2009 is further disinflation and possibly deflation.

In the second component, I will argue that because of the special circumstances in which we find ourselves, monetary policy should focus more squarely on quantitative measures, beginning with the monetary base, to get some idea of the thrust of policy with respect to inflation.

In the third component, I will consider the Fed’s balance sheet. There I will stress that while the monetary base has expanded at an extraordinarily fast pace during the fall and winter, much of that expansion has been closely related to the Fed’s lender-of-last-resort function, and cannot be counted on to keep expectations of disinflation and deflation at bay.

James Bullard is president and chief executive officer of the Federal Reserve Bank of St. Louis. He directs the activities of the Bank’s head office in St. Louis as well as its three branches in Little Rock, Ark., Louisville, Ky. and Memphis, Tenn. In addition, he represents the Bank on the Federal Open Market Committee, the Federal Reserve’s chief monetary policymaking body.

Here, IMO, is the money quote:

“The risk of further disinflation and a possible deflationary trap

Let me turn now to the first part of the thesis: that the primary near-term risk for monetary policy is continued disinflation and a possible deflationary trap. Core personal consumption expenditures (PCE) inflation has been negative during each of the last three months of 2008—in December, the rate was about minus three-tenths of one percent.

The readings for the core consumer price index (CPI) inflation during these three months were similar, near zero to slightly negative. It is true that measured from one year ago, core PCE and core CPI inflation have not yet turned negative, but given the sharp drop-off in real activity at the end of 2008, it may be unwise to focus solely on the measures from one year ago at this juncture. I think it is reasonable to say that core inflation is
running at zero to slightly negative rates at this time. “

This has been the problem with policymakers all over the world at this point: they keep looking at YOY numbers, which given the rapid rise in commodity prices (ie, oil) and thereafter wholesale price increases, they have quite a bit of blow-off to deal with before they see “true” deflation in the YOY numbers. Trouble is, at the rate deposits and credit are being destroyed all over the world, by the time the YOY inflation goes actual negative, the deflationary mindset will be pretty well entrenched and going in the minds of consumers.

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