ST. LOUIS - Federal Reserve interest rate hikes may be "quite a ways away," but at some point the Fed must "renormalize" rates and shrink the monetary base if it is to keep inflation contained, St. Louis Federal Reserve Bank President James Bullard said Monday.
Bullard, in an interview with Market News International, said that if the federal funds rate remains at zero for several years it will be sign that the economy is in a Japanese-style "deflation trap."
He said the Fed's ability to pay interest on reserves will be a very important tool for the central bank when the time eventually does come to raise the federal funds rate, but doubted whether that tool alone will be sufficient. Nor will the Fed's assets run off quickly enough. So he said the Fed will likely have to sell assets to absorb reserves and tighten credit as the economy recovers.
Bullard, who will be a voting member of the Fed's policymaking Federal Open Market Committee next year, did not say when he thinks the Fed should begin tightening what he called a "very accommodative" monetary policy. He said it will be "state contingent," i.e. dependent upon the evolving state of the economy and financial markets.
For now, he expressed optimism that there will be "positive GDP growth" and "positive job numbers" in the second half, with economic and financial conditions improving further in 2010, but he said there are downside risks to the outlook, including commercial real estate and the possibility that heavy federal borrowing could push up long-term interest rates as the economy recovers. So he suggested there is no urgency to firm policy.
Bullard suggested that one option the Fed could explore would be to go to a European-style "corridor system" of official rates.
Bullard said he sees "no reason why we can't run a monetary policy that gets it just right, that allows the economy to recover without inflation." But he acknowledged that the Fed will need to "make good judgments and get the timing right."
And he said there will be "tough decisions" for him and his fellow policymakers to make. For instance, what does the Fed do if inflation and/or inflation expectations are starting to rise while the economy remains soft? "These are the kind of scenarios we might face over the next couple of years as the economy recovers," he said.
The FOMC has been saying since early this year that it expects to keep the federal funds rate, which has been targeted between 0% and 0.25% since last December, "exceptionally low ... for an extended period."
Bullard said the purpose of that commitment is, in theory, to give the economy "some additional impetus" and end the recession faster by convincing people that credit will stay easy longer than usual. But he said "there is some legitimate question whether that really works in the real world." And he expressed some misgivings about keeping rates too low too long, although he is not prepared to set any time limit.
Recalling that the Fed held the funds rate at very low levels earlier in the decade and that this "contributed" to the housing boom and bust that led to the current financial crisis, Bullard said that this time around, "We will be a lot more conscious about this notion that you would renormalize interest rates at some point."
"I think it's a ways away -- maybe quite a ways away," he continued. "But you would at some point say, 'we're going back to a normal interest rate pattern' and that 'we've done what we can as far as trying to mitigate the downturn' because that (earlier 'considerable period of low rates) did seem to contribute to other types of problems."
"I think there will be far more consciousness of that (potential of low rates to fuel asset booms and busts) than there was in 2003 and 2004," he added.
San Francisco Fed President Janet Yellen said in early July that the funds rate may need to stay at zero "for several years." But Bullard said that "if the federal funds rate is at zero several years from now we'll be in a Japanese style deflation trap or a very low inflation trap. The goal is to avoid that outcome in 2009."
Asked whether he thinks the Fed should preemptively tighten or wait until recovery is well underway and bringing down unemployment, Bullard did not answer with specificity.
But "you want to run this optimal policy," he said. "You're in a bad state today. You would like to see the economy improve and get back to a more normal growth path without creating a lot of inflation."
"You're going to have to make judgments along the way about what the optimal policy is along this growth path," he continued. "I don't think you really can say ahead of time, 'we're going to be looking at this thing or that thing.' You have to take all the data in total, the entire picture, not the least of which is continued improvement in financial markets, which I think has to happen over the next year."
He said "financial turmoil is abating," but said there is still "a lot of repair work" that needs to be done.
As for the pace of tightening once it begins, Bullard expressed skepticism at the incremental approach taken by the Fed the last time it was in tightening mode in 2004-06, when it raised the funds rate by 25 basis points at 16 successive meetings.
"I don't think there was any theory that told you that you were supposed to go up a quarter point at every single meeting," he said. "I never heard any theory that you should march up like that."
As far as he's concerned, the pace of tightening is "going to be more state contingent than that. It has to depend more on how the data comes in on the economy."
In the earlier tightening campaign, Bullard said the FOMC "kind of got started on this quarter point thing, and kind of got locked into it. But really it should be more dependent on the data as it comes in than that one was."
At the Kansas City Fed's recent symposium in Jackson Hole, Wyoming, University of California-Santa Cruz professor and former Fed staffer Carl Walsh said the Fed should tighten aggressively when it tightens, and Bullard said "that's something I'll look at pretty carefully."
Another thing he said is "very important to watch" is the size of the monetary base and its impact on broader measures of the money supply.
Monetary theory teaches that "if you double the money supply, eventually you'll double the price level," noted Bullard, adding that the Fed has in fact doubled the monetary base (reserves plus currency in circulation).
But he said a "key question" is: "how permanent" is the increase in the base? He said another issue is "does it really feed into the money supply or does it just stay at the Fed?"
Still another issue is "how fast does the economy recover?" said Bullard. "If it recovers more quickly, you would expect banks to turn around and lend out and not hold reserves at the Fed."
Finally, he said the impact of the monetary base on the broad money supply -- and in turn on output and prices -- "depends on future monetary policy."
"If you put a lot of monetary base out there today, and we take it all back tomorrow, we normally don't think that's very inflationary; it really almost has no impact at all," he said. "So the question is, if you put all this monetary base out there and you leave it out there and it eventually gets into the money supply and people see that you don't have any intention of bring it back, that can lead to an eventual doubling of the price level."
Bullard disputed those who have minimized the impact of money growth on inflation by comparing past money growth rates and inflation rates. "This (current money expansion) is really qualitatively very different and quantitatively very different," he said. "It's one thing to talk about small movements in the monetary base and say you can see how they're showing up in inflation versus more than doubling the monetary base."
He said the Fed can make the reserve portion of the monetary base stay at the Fed "if we pay high enough interest on reserves," but suggested that may be problematical.
Bullard said the Fed's ability to pay interest on reserves, thereby encouraging banks to keep money at the Fed instead of lending it out in response to rising credit demand in a recovering economy, will be "a leading candidate tool to manage our large balance sheet going forward," even though he acknowledged that it is somewhat "untested" and failed to put a floor under the funds rate last fall.
If deployed effectively, he said, it will aid the Fed in tightening, both by helping the Fed enforce a higher funds rate target and by limiting credit flows by discouraging lending. "You're definitely tightening," said Bullard.
But aside from "unresolved" technical issues, Bullard pointed to other problems with interest on reserves. Anticipating that excess reserves will exceed $1 trillion by year's end, he said, "If you start to pay substantial interest on reserves, it's going to be a fair amount of money." And Congress could object to all the interest the Fed would be paying to the banks.
"So I think it's a tool, but we can't just rely on interest on reserves to do everything for us going forward -- not with the size of the balance sheet," he said.
"We may be able to buy time on that, because it may be a while before we raise interest rates or have to raise interest rates on reserves," he went on. "Right now we're at a quarter of a percent, but if we get up to 3% or 4% on $1 trillion it starts to be a lot. So I think it's a tool, but probably not the only one."
"We can't rely just on interest on reserves to manage the balance sheet," he continued. "We're going to have to sell off a portion of our portfolio when the time comes."
If the Fed finds that the monetary base is propagating broader money supply growth and threatening inflation and if interest on reserves proves to be an inadequate tool, selling assets is "what we'd have to do," said Bullard.
"Some of those assets are going to naturally run off, but they don't run off fast enough really that you'd really run your excess reserves down quickly enough," he said. "If the economy recovers very slowly then you might be able to just let your assets run off, but it takes awhile -- seven, eight, 10 years. That's a little slow to be completely confident that it's not going to lead to some inflation."
Bullard said that "one of the issues going forward is that maybe you'd have a corridor system like other central banks around the world have, where you have a lower limit given by the interest on reserves and then an upper limit via another standing facility and then the policy rate trades in between the two."
But he called that idea "speculation" and said "there's really been no discussion of that (on the FOMC) so far."
Bullard said he does not expect a "double dip" recession, but said there are downside risks. Commercial real estate is "a risk for the economy," he said, adding, "how big a drag on the overall economy is an open question. It's a risk that could be significant, but it could occur at a slow enough pace that it doesn't" unduly harm the economy.
Rising long-term interest rates are "a significant risk." He said that not just the United States but all major governments are borrowing heavily to fund their fiscal response to the financial crisis. So far, he said that risk "doesn't seem to be manifesting itself."
Bullard warned that "any appearance that the Federal Reserve or other central banks were going to monetize" government debt "would put upward pressure on interest rates." For that reason, he said it is vital that the Fed remain independent of political pressure.
In other comments, Bullard warned not to "bet the farm" that a recessionary "output gap" -- the difference between actual and potential growth, as expressed in "slack" use of labor and other resources --- "is going to keep everything under control" on the wage-price front. He pointed to the 1970s, when both inflation and unemployment were in double digits.
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