NEW YORK - St. Louis Federal Reserve Bank President James Bullard warned Friday about the inflationary risks of expanding the Fed's balance sheet and about basing monetary policy on what he considers faulty assumptions about the size of the "output gap" -- the difference between actual and potential GDP.
It will take "a long time" to recover from the bursting of the housing bubble and the Fed should not be trying to reflate that bubble, Bullard said in a speech prepared for delivery at Simon Fraser University in Vancouver, Canada.
Bullard, who is not a voting member of the Fed's policymaking Federal Open Market Committee this year, also questioned the credibility of calendarized commitments to zero interest rates. He was even more skeptical of trying to tie the zero federal funds rate to unemployment or other economic triggers as Chicago Fed President Charles Evans has recommended.
While opposing an "extended period" of zero rates, Bullard was an early proponent of the second round of quantitative easing in November 2010 which added $600 billion to the Fed's balance sheet.
However, he seemed to express reservations about supporting a QE3 at this time, warning "increases in the size of the balance sheet entail additional inflationary risks if accommodation is not removed at an appropriate pace."
Those who have expressed an openness to QE3 or other easing measures have often cited the wide "output gap" -- often expressed in terms of the large amounts of resource slack, particularly in the labor market. But Bullard urged caution in taking that approach.
He noted that "most components of U.S. GDP have recovered to their 2007 Q4 peak," but said "the exception is the components of investment related to real estate." And "these components of GDP will take a long time to recover."
"It is therefore not reasonable to claim that the 'output gap' is exceptionally large," Bullard continued, adding, "It is neither feasible nor desirable to attempt to re-inflate the U.S. housing bubble of the mid-2000s" because "the crisis has likely scared off a cohort of potential homeowners, who now see home ownership as a much riskier proposition than renting."
Noting that U.S. homeowners have about $9.9 trillion in debt outstanding against $712 billion of equity, Bullard said that "to get back to the normal (loan to value ratio of 58.4%) households would have to pay down mortgage debt by about $3.7 trillion, about one-quarter of one year's GDP."
"This will take a long time," he said. "It is not a matter of business cycle frequency adjustment."
What's more, Bullard quoted economists as contending that "some households may not be able to react normally to easy monetary policy" because "they cannot borrow more against their home values."
As evidence, he observed that "states with the largest declines in home values have the weakest recoveries."
And so "monetary policy may not be able to reach the constrained households," he said, suggesting further quantitative easing might accomplish very little.
At its Jan. 25 meeting, the FOMC extended the expected period of zero rates from mid-2013 to late-2014 in a bid to hold down interest rates across the yield curve and induce more spending and investment. but Bullard was dubious about the effectiveness of that strategy.
"By shifting this date, the Committee, at least according to some models, can influence financial market conditions and provide further monetary accommodation if it so desires," he said, but he was skeptical: "The communications tool works inside models but has some important caveats for actual policy application."
"Namely, it is not clear how credible actual announcements can be," he said. "If the economy is performing well at the point in the future where the promise begins to bite, then the Committee may simply abandon the promise and return to normal policy."
"But this behavior, if understood by markets, would cancel out the initial effects of the promise, and so nothing would be accomplished by making the initial promise," he added.
As for proposals to tie a promise of near-zero policy rates to actual outcomes in the economy, such as the unemployment rate, Bullard said, "Most proposals use an actual unemployment rate but an anticipated inflation rate. This asymmetry is hard to justify."
"Unfortunately, unemployment rates have a checkered history in advanced economies over the last several decades," he said.
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