WASHINGTON (MNI) – The following are excerpts of a presentation
Thursday by St. Louis Federal Reserve Bank President James Bullard
discussing price level targeting and nominal GDP targeting. Bullard’s
presentation, “A Singular Achievement of Recent Monetary Policy,” is
part of the Theodore and Rita Combs Distinguished Lecture Series in
Economics at the University of Notre Dame.

During his presentation, Bullard discussed the large shock to the
U.S. economy in 2008-2009 and what should have happened if monetary
policy reacted in just the right way to the shock. Given that “price
level targeting” can be the optimal policy according to some leading
theories, Bullard said that one possibility is that the Federal Open
Market Committee (FOMC) should have maintained the price level on its
established path. “The FOMC has in fact essentially behaved as if it
was price level targeting. In this sense, policy since 2008 looks close
to optimal,” he said, calling this “a singular achievement of recent
monetary policy.”

Bullard also discussed the aftermath of the large shock to the
economy. “As the dust has settled since 2008, it has become more and
more apparent that U.S. real GDP is growing along a different path than
the bubble-induced, pre-crisis path,” he said. He noted this is
consistent with key findings of Carmen Reinhart and Kenneth Rogoff, who
analyzed financial crises over the last 800 years and concluded that
post-financial crisis economies grow more slowly.

Bullard said that the Reinhart-Rogoff effect has implications for
future monetary policy, given that some have called for switching to a
nominal GDP target. “Attempting to target nominal GDP without
adjustment for the Reinhart-Rogoff effect could be an unmitigated
disaster,” he said.

Price Level Targeting and the Actual Price Level

In looking closer at price level targeting, Bullard cited a leading
theory that has been extensively analyzed by Michael Woodford and his
co-authors. Bullard stated that the main idea in the theory is that
prices are “sticky” and therefore do not adjust immediately to changes
in supply and demand conditions. He noted that optimal monetary policy
corrects for this deficiency. “When the economy is hit by a shock, the
optimal policy returns the price level back to its previous path.”
Thus, he said that the behavior of the aggregate price level might be
viewed as a “signature” of optimal policy.

The advice from Woodford’s model, Bullard said, is that
policymakers should take care to keep the price level on an established
path when a large shock hits the economy. Indeed, this basic advice
seems to have been implemented in the U.S., he said, noting that the
current U.S. price level is not far from the path established during the
mid-1990s. “This could be interpreted as ‘monetary policy has done
exactly what it was supposed to do in response to the large shock,'” he

Bullard said that the FOMC simply kept inflation close to 2 percent
even in the face of the large shock, rather than explicitly stating that
maintaining the price level path was an ultimate goal.

The Reinhart-Rogoff Effect

Bullard stated that some shocks may be so large and so unusual that
they cause especially severe damage to the economy. To that end,
Reinhart and Rogoff showed that the aftermath of major financial crises
tends to be marked by many years of slower-than-normal growth. Bullard
noted that this seems to have happened in the U.S. “Before 2007, growth
was likely artificially high due to the housing bubble. After 2009,
growth has likely been slowed by deleveraging,” he said.

Bullard noted that some have advocated that current U.S. monetary
policy should switch to a nominal GDP target. “Nominal GDP includes
both the price level and real GDP in one aggregate; it does not separate
the two,” he explained. “The aggregate price level seems to be right
about on target. Real GDP, on the other hand, seems to have been
markedly influenced by the Reinhart-Rogoff effect,” he said, stating
that real GDP has grown slowly in recent years.

In fact, simply comparing nominal GDP with its 1990-2008 trend
might lead one to conclude that U.S. monetary policy has been far off
track — that is, way too tight — in recent years, Bullard said.
However, “The one variable the Fed can control in the medium and long
term, the aggregate price level, is exactly on track,” he said. “The
problem is the failure to adjust nominal GDP for the Reinhart-Rogoff
effect.” After adjusting appropriately for the Reinhart-Rogoff effect,
nominal GDP is about on target as well.

Bullard discussed his work with Stefano Eusepi on the consequences
for monetary policy of understating a productivity slowdown. Research
by Athanasios Orphanides documents that this is what happened in the
1970s. Bullard said, “We found that it would take policymakers several
years to learn that their policies were inappropriate; in the meantime,
about 300 basis points of unintended inflation would be created.”

He concluded, “The consequences of nave NGDP targeting, without
appropriate adjustment, might be more severe today.”

** MNI Washington Bureau: 202-371-2121 **