James Bullard, the President of the St. Louis Federal Reserve Bank, is a very fine economist, having worked his way up the ranks at the St. Louis Fed after joining the research department at the St. Louis Fed in 1990, as newly minted Ph. D. from Indiana University, publishing his research widely in leading journals (and also contributing an entry on “learning” to Business Cycles and Depressions: An Encyclopedia which I edited). Bullard may just be the most centrist member of the FOMC (see here), and his pronouncements on monetary policy are usually measured and understated, eschewing the outspoken style of some of his colleagues (especially the three leading inflation hawks on the FOMC, Charles Plosser, Jeffrey Lacker, and Richard Fisher).
But even though Bullard is a very sensible and knowledgeable guy, whose views I take seriously, I am having a lot of trouble figuring out what he was up to in the op-ed piece he published in today’s Financial Times (“Patience needed for Fed’s dual mandate”) in which he argued that the fact that the Fed has persistently undershot its inflation target while unemployment has been way over any reasonable the rate consistent with full employment, is no reason for the Fed to change its policy toward greater ease. In other words, Bullard sees no reason why the Fed should now seek, or at least tolerate, an inflation rate that temporarily meets or exceeds the Fed’s current 2% target. In a recent interview, Bullard stated that he would not have supported the decision to embark on QE3.
To support his position, Bullard cites a 2007 paper in the American Economic Review by Smets and Wouters “Shocks and Frictions in US Business Cycles.” The paper estimates a DSGE model of the US economy and uses it to generate out-of-sample predictions that are comparable to those of a Bayesian vector autoregression model. Here’s how Bullard characterizes the rationale for QE3 and explains how that rationale is undercut by the results of the Smets and Wouters paper.
The Fed has a directive that calls for it to maintain stable prices as well as maximum employment, along with moderate long-term interest rates. Since unemployment is high by historical standards (8.1 per cent), observers argue the Fed must not be “maximising employment”. Inflation, as measured by the personal consumption expenditures deflator price index, has increased to about 1.3 per cent in the year to July. The Fed’s target is 2 per cent, so critics can say the Fed has not met this part of the mandate. When unemployment is above the natural rate, they say, inflation should be above the inflation target, not below.
I disagree. So does the economic literature. Here is my account of where we are: the US economy was hit by a large shock in 2008 and 2009. This lowered output and employment far below historical trend levels while reducing inflation substantially below 2 per cent. The question is: how do we expect these variables to return to their long-run or targeted values under monetary policy? That is, should the adjustment path be relatively smooth, or should we expect some overshooting?
Evidence, for example a 2007 paper by Frank Smets and Raf Wouters, suggests that it is reasonable to believe that output, employment and inflation will return to their long-run or targeted values slowly and steadily. In the jargon, we refer to this type of convergence as “monotonic”: a shock knocks the variables off their long-run values but they gradually return, without overshooting on the other side. Wild dynamics would be disconcerting.
What is wrong with Bullard’s argument? Well, just because Smets and Wouters estimated a DSGE model in 2007 that they were able to use to generate “good” out-of-sample predictions does not prove that the model would generate good out-of-sample predictions for 2008-2012. Maybe it does, I don’t know. But Bullard is a very smart economist, and he has a bunch of very smart economists economists working for him. Have they used the Smets and Wouters DSGE model to generate out-of-sample predictions for 2008 to 2012? I don’t know. But if they have, why doesn’t Bullard even mention what they found?
Bullard says that the Smets and Wouters paper “suggests that it is reasonable to believe that output, employment and inflation will return to their long-run or targeted values slowly and steadily.” Even if we stipulate to that representation of what the paper shows, that is setting the bar very low. Bullard’s representation calls to mind a famous, but often misunderstood, quote by a dead economist.
The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.
Based on a sample that included no shock to output, employment, and inflation of comparable magnitude to the shock experienced in 2008-09, Bullard is prepared to opine confidently that we are now on a glide path headed toward the economy’s potential output, toward full employment, and toward 2% inflation. All we need is patience. But Bullard provides no evidence, not even a simulation based on the model that he says that he is relying on, that would tell us how long it will take to reach the end state whose realization he so confidently promises. Nor does he provide any evidence, not even a simulation based on the Smets-Wouters model — a model that, as far as I know, has not yet achieved anything like canonical status — estimating what the consequences of increasing the Fed’s inflation target would be, much less the consequences of changing the policy rule underlying Smets-Wouters model from inflation targeting to something like a price-level target or a NGDP target. And since the Lucas Critique tells us that a simulation based on a sample in which one policy rule was being implemented cannot be relied upon to predict the consequences of adopting a different policy rule from that used in the original estimation, I have no idea how Bullard can be so confident about what the Smets and Wouters paper can teach us about adopting QE3.
PS In the comment below Matt Rognlie, with admirable clearness and economy, fleshes out my intuition that the Smets-Wouters paper provides very little empirical support for the proposition that Bullard is arguing for in his FT piece. Many thanks and kudos to Matt for his contribution.