St. Louis Fed President James Bullard gave his interpretation of the implications of some recent innovations in Fed policy tools and on how they fit with the so-called dove and hawk factions. Bullard indicated that the current policy of an extended zero fed funds rate could lead to bubbles if the Fed is not paying attention to either inflation or unemployment. Being somewhat technical, he was critical of the extended guidance on the fed funds rate (being exceptionally low through 2014), essentially calling it an interest rate peg. The following is from the St. Louis Fedís summary of the speech.
Bullard discussed the Federal Open Market Committee's (FOMC's) decision at the January 2012 meeting to name an explicit, numerical inflation target of 2 percent. While some discussion has suggested that inflation targeting is inconsistent with the Fed's dual mandate to promote maximum employment and stable prices, Bullard said that "inflation targeting is perfectly consistent with the Fed's dual mandate." He added that "much of the discussion about the dual mandate is, in my view, really about the nature of the Fed's reaction function to economic events," which is separate from setting an inflation target. In addition, "inflation targeting is consistent with hawks, doves and even bubbles," he said.
"Naming an explicit numerical inflation target is neither hawkish nor dovish," Bullard said. "It is simply a recognition that the central bank controls the medium- to long-run rate of inflation, and that in order to minimize uncertainty the central bank may as well say what it is trying to achieve," he stated.
"Heavy focus on the nature of the Fed's interest rate reaction function in the current environment is questionable," Bullard said. "There are many issues at least as important, and resolution of any of those issues could change the argument for a particular reaction function."
For instance, most monetary policy is not currently about interest rate adjustment, he said, adding that so-called "unconventional" policy (e.g., quantitative easing) has come to the fore. In addition, he noted that there has been discussion concerning the possibility that current Fed policy may lead to "bubbles" in the economy. This can occur if the weights on inflation and the output gap in the policy rule are too small, he said. "In effect, the policymaker must be sufficiently aggressive in responding to shocks," Bullard said. One of the worst policies in this particular model is to place zero weight on both inflation and the output gap, which is also known as the "interest rate peg" policy because interest rates never change, he added. Actual policy rates in the U.S. have been near zero since December 2008 and are projected to remain there until late 2014, which Bullard said could be viewed as an approximation to the "interest rate peg" policy.