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Analysis
Regime change from ‘new narrative’

Regime change from ‘new narrative’

Bullard’s monetary shake-up with international implications 

by David Marsh

Mon 18 Jul 2016

The monetary about-face by James Bullard, the hawk-turned-dove St. Louis Federal Reserve Bank president, has wide implications for international central bankers. Bullard’s ‘new narrative’, elaborated at an OMFIF meeting in St. Louis, could shake up how the Fed views the world, reflecting deep-seated changes in the functioning of money and economics.

Bullard’s shift, which he announced on 17 June and has been explaining in statements since, reflects intensive discussions within the St. Louis Fed about what appears to be a semi-permanent transition to very low real interest rates on government bonds – in the US and around the world.

It ties in with a growing recognition that much-expanded central bank balance sheets – which have ballooned as a result of quantitative easing efforts to inject liquidity into fraught banking systems and raise inflation rates – are a fact of life and will not be significantly lowered for many years.

If other members of the rate-setting Federal Open Market Committee adhere to the St. Louis Fed’s ‘new narrative’, this could mark a revolution in monetary policy. A move in Bullard’s direction could require significant changes to the framework of the FOMC’s meeting. The committee would be looking more for longer-term deviations from the ‘regime’ the economy finds itself in, rather than shorter-term changes in the economic and monetary environment.

There are signs that Bullard’s stance may be winning support. Neel Kashkari, president of the Minneapolis Fed, said at the OMFIF meeting in St. Louis that he sympathised with Bullard’s fresh approach. Robert Kaplan of the Dallas Fed threw his weight behind general efforts by central bankers to improve communications to reflect their new position.

Bullard’s announcement came as a surprise to markets and to many at the Federal Reserve. But it was presaged by a series of interventions in recent months in which he expressed increasing antipathy to the confusing signals emanating from the FOMC’s ‘dot plot’ – containing projections of interest rates under what committee members term ‘appropriate’ monetary policy.

Bullard has been attempting to bridge a credibility-denting gap between the very low projected interest rates foreseen by financial market economists and those predicted by FOMC members. He has come up with an intellectual framework to align the markets’ rather bearish (but ultimately more accurate) assessment and that of the committee’s members.

The proposals from St. Louis may provide a gradual means to change the Fed’s interest rate-setting arrangements, as a full-frontal switch of rules and procedures by the Fed’s Board would be difficult to accomplish.

Janet Yellen, the Fed chair, does not appear to have been consulted about Bullard’s announcement. Although some might believe his radical rethink represents a challenge to her authority, she can take some comfort from the conversion of a one-time hawk to an adherent of her own somewhat dovish stance.

This is part of a worldwide trend. Monetary leaders of the G7 advanced countries – Yellen, Haruhiko Kuroda of the Bank of Japan, Mario Draghi of the European Central Bank, Mark Carney of the Bank of England and Stephen Poloz of the Bank of Canada – have been in their current posts for a collective 17 years. Only one – Yellen (last December) – has raised interest rates during this time. Moreover, it has become increasingly likely that two of the most dovish governors – Kuroda at the BoJ and the ECB’s Draghi – will not raise rates before their terms expire in 2018 and 2019 respectively.

After more than two years of encouraging expectations that the next move in UK interest rates will be upwards, Carney has held out the prospect of monetary easing to compensate for the economic fall-out of the UK vote to leave the European Union. However, last week the BoE’s monetary policy committee – some of whose members were not pleased at Carney’s end-June pre-announcement of an interest rate cut – agreed to put UK credit easing on hold until August.

Bullard says, as a result of the changed view on the economy, he now wants only one mini-hike this year. He would then like to put rates on hold through 2018, with a median rate of 0.63% for the economic ‘regime’ the St. Louis Fed foresees for the next 30 months. He is reckoning on real output growth of 2%, an unemployment rate of 4.7%, and an inflation rate of 2%, based on the ‘trimmed mean PCE’ rate of the Dallas Fed, now at 1.86%.

Circumstances such as a switch to higher productivity or higher real interest rates, or a move into recession, may lead to a change in this regime – necessitating a corresponding change in policy. But this switch, Bullard’s team says, is ‘not forecastable’. Barring shocks to the economy, the present circumstances look sustainable: output growth close to trend, steady unemployment near current values, and trimmed-mean inflation close to target but not rising rapidly.

Backing up his misgivings about the ‘dot plot’, Bullard last month refrained from placing a dot for the longer-run forecast on the Fed’s graphic for forecasting rates, sticking to 0.63% for 2017 and 2018, well below levels projected by the other 16 FOMC members. If momentum for the ‘new narrative’ gains ground, Bullard could trigger the dot plot’s demise – a feat in which he would no doubt take quiet pride.

David Marsh is Managing Director of OMFIF.

To listen to an audio recording of James Bullard and Minneapolis Fed President Neel Kashkari discussing monetary policy and the outlook for the US economy at the OMFIF meeting in St. Louis, click here.

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