The departure point for Bullard's paper is published work by Benhabib et. al. on "The Perils of Taylor Rules" from 2001. A Taylor rule (discussed here) is a policy rule for a central bank that dictates how the central bank's interest rate target should be set in response to the inflation rate and the "output gap" (the deviation of real GDP from its desired level). Benhabib et. al. argued that, if a central bank follows a Taylor rule, then it is possible that the economy ends up in a permanent state with deflation and a zero nominal interest rate.
Why should we be concerned about this? As Bullard argues, much macreconomic analysis and policy discussion is carried on in the context of Taylor rules. Further, the Fed's actual behavior seems to conform to a Taylor rule. In the current context, according to Bullard, the US economy is getting dangerously close to the a state where the nominal interest rate is zero for an extended extended period, and could slip into an extended period of deflation. Why is this bad? Bullard says:
Perhaps the most important consideration is that in the unintended steady state the policymaker loses all ability to respond to incoming shocks by adjusting interest rates— ordinary stabilization policy is lost, and possibly for quite a long time. In addition, the conventional wisdom is that Japan has suffered through a “lost decade”partially attributable to the fact that the economy has been stuck in the deflationary, low nominal interest rate steady state illustrated in Figure 1.So the idea is that we don't want to be in the zero-nominal-interest-rate world, as then the Fed has nothing to do, and since Japan suffered a lost decade, in part associated with some deflation, we want to avoid looking like that, even if we don't understand what deflation had to do with the decade getting lost.
Bullard suggests two remedies for the problem he lays out, which are (i) The FOMC should tone down this language:
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.The suggestion seems to be that there should be a commitment to raise rates sometime in the future. (ii) Bullard says:
Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.
My comments are as follows:
Active Taylor-type rules are so commonplace in present day monetary policy discussions that they have ceased to be controversial.I'm not sure this is true or not. In any case, Taylor rules should be controversial. Take the 2001 Benhabib et. al. paper for example. The authors basically drop a Taylor-rule central bank into two different example economies. The first one is a Sidrauski-type money-in-the-utility function economy with a fixed endowment of goods. We know exactly what an optimal policy is in this economy - it's a Friedman rule with a zero nominal interest rate and deflation at the rate of time preference. There is nothing bad about the "bad" steady state here - it's the "good" steady state that is actually suboptimal. The other example is a sticky price economy with monopolistic competition. In this economy an optimal monetary policy involves having a constant inflation rate that trades off three distortions: the sticky price distortion, the Friedman rule (positive nominal interest rate) distortion, and the monopolistic competition distortion. In neither example is the Taylor rule an optimal policy rule that the central bank would choose to follow.
Any discussion of policy choices by a central bank needs to be conducted in models where the policy rules chosen by the policymakers make sense in terms of the information they have, their constraints, and their objectives.
Deflation and Japan
Most of what I have read recently on the potential for deflation in the United States currently and how this relates to the Japanese "lost decade" goes as follows. Problems in Japan started with a collapse in asset prices and an ensuing financial crisis. There was also a deflation and very low growth in GDP. In the US we have seen the collapse in asset prices, and the financial crisis. If we allow deflation, then surely we will have a lost decade of weak GDP growth.
I have not done research on Japan's lost decade, but what I know about it tells me that Japanese experience in the 1990s does not look much like recent US experience. The lost decade in Japan seems to have been about repeated financial crises due to an inability of policymakers and regulators to deal with problems in the financial industry. While the US potentially has future financial problems lurking (Fannie Mae, Freddie Mac, and unresolved moral hazard problems), problems in our financial industry were, for the most part, dealt with swiftly.
Someone will have to be more explicit about what caused the deflation in Japan, how that was connected to poor macroeconomic performance, and what that has to do with our current predicament in the United States. I'm not convinced.
Bullard tells us that if we get a "negative shock" in the future, the Fed should buy long-term Treasury securities, as he feels this is effective, both in reducing long-term bond yields, and in increasing the inflation rate and inflationary expectations. He cites evidence that quantitative easing in the US and the UK had these effects. My response to this is a series of questions:
1. What negative shocks does Jim have in mind? Lower-than-expected inflation? A low GDP report? More bad news on sovereign debt in Europe? Is the purchase of long-term Treasuries the solution to every "bad" shock on the horizon? Why?
2. Does this mean the Fed is now interested in fine-tuning?
3. What theory explains the potential ability of the Fed to manipulate the term structure of interest rates by swapping interest-bearing reserves for long-term Treasuries? I need some structural empirical evidence - not just correlations.
4. If the Fed has the ability to lower long-term interest rates, and this is a good thing, why does the Treasury issue long-maturity securities if this only serves to crowd out private investment?
5. The Fed can get more inflation (though not much more) by reducing the interest rate on reserves to zero. If the Fed indeed wants more inflation, why doesn't it do that?