NEW YORK – The Federal Open Market Committee’s decision to set a 2% explicit, numerical inflation target is “an important step forward,” that could stop the nation from misreading the output gap and, thereby, avoiding a “looming disaster” caused by keeping rates near zero for too long, according to Federal Reserve Bank of St. Louis President and CEO James Bullard.

“This is an important development, as it may prevent the U.S. from repeating the mistakes of the 1970s, in which a misreading of the size of the output gap led the Fed to maintain easy monetary policies for far too long,” Bullard told the Union League Club of Chicago, according to prepared text of the speech, which was released by the Fed.

The target will be flexible, he said, “matching a desire to keep inflation low and stable in the long run with the challenge of providing some business cycle stabilization in the shorter term. One of the key issues in stabilization policy is the benchmark against which economic performance is measured.”

Economic performance, should not be “continually compared to the bubble-influenced mid-2000s,” which he said could be seen “as a one-time, permanent shock to wealth.”

He also noted, “It does not make sense to ignore some inconveniently volatile prices, like those for gas or food, when discussing the inflation rate actually faced by U.S. households.”

Targeting, he said, “makes sense because the central bank can only influence inflation and not any real macroeconomic variable in the long run.”

While the FOMC has other tools that can give temporary direction smooth “bumpy” spots, a process Bullard called “monetary stabilization policy.” While meaningful, smoothing’s effects are usually “not particularly large.”

“Flexible inflation targeting enables central banks to conduct a stabilization program and make it as effective as it can be made without departing from the longer-run goal of keeping inflation low and stable,” Bullard said.

Looking at the crisis of the 1970s, he said, policymakers learned that “high inflation just causes problems and does nothing to help address fundamental macroeconomic issues.”

The key to flexible inflation targeting is to realize where the economy should “ideally be operating versus where it is actually operating.”

Recently, the belief sprung up that a very large “output gap” that keeps “inflation at bay” exists “and is fodder for keeping nominal interest rates near zero into an indefinite future.”

If that were the case, he said, it would be “very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates,” which would be a “looming disaster.”

A near-zero rate policy, he said “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.”

Those who save are “punished” by near-zero rates, he said, and that tends to be older citizens. “These low rates of return mean that some of the consumption that would otherwise be enjoyed by the older, asset-holding households has been pared back.”

Also, younger people, who may be willing to buy on credit, especially with low interest rates, “faces high unemployment rates and tighter borrowing constraints, which may limit its ability and willingness to leverage up to finance consumption. Consequently, the consumption of the older generations may be damaged by the low real interest rates without any countervailing increase in consumption by other households in the economy. In this sense, the policy could be counterproductive,” he said.

“Again, these broader effects of a low real interest rate policy might not be so critical in an environment where the low yields last for a few quarters, but they may be significantly more important as the length of time is stretched out over many years,” according to Bullard.

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