What output gap?
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| James Bullard |
This speech is really about how to interpret the recent performance of the U.S. economy. Is the conventional interpretation, that we are far below "potential" GDP owing to "deficient demand," the correct view? Or should we instead be thinking in terms of a large negative shock to "potential" GDP, with unemployment returning slowly to its natural rate, according to its normal dynamic (see here)?
I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along it's original growth path. This part is incorrect given the model I have in mind here.) The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.
The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed's current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the "bubble period" as the economy being at, and not above, potential). Among other things, he says:
But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.
Precisely how such a policy "distorts fundamental decision-making" needs to be spelled out more clearly (though he does offer a couple of examples that hinge on a presumed ability on the part of the Fed to influence long-term real interest rates). I am sure that many of you have your own favorite examples.
At any rate, I think this is a nice speech because it challenges us to think about the recent U.S. recovery dynamic in a different way. And if recent history has shown us anything, it's shown that we shouldn't grow complacent over what we think we understand.
Update available here: The trend is your friend (until it ends)
Update: The "terrifying" James Bullard offers a reply to Tim Duy here.
Update available here: The trend is your friend (until it ends)
Update: The "terrifying" James Bullard offers a reply to Tim Duy here.
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