By Steven K. Beckner

(MNI) – St. Louis Federal Reserve Bank President James Bullard
warned Monday that by, in effect, pegging the federal funds rate at zero
for an extended period the Fed may be risking the creation of new asset
bubbles.

Bullard said the Fed needs to adjust monetary policy tighter or
looser as inflation and unemployment change, rather than leave it
unchanged for long periods of time to avoid “multiple equilibria” or
bubbles from developing.

Bullard defended the Fed’s policy of setting a 2% inflation target,
saying that it is consistent with the Fed’s statutory “dual mandate” and
is neither “hawkish” nor “dovish.”

Bullard described as “questionable” the focus on the Fed’s federal
funds rate “reaction function” in the current environment where the
funds rate is near the zero lower bound and monetary easing has to be
done through “unconventional” measures such as large-scale asset
purchases.

Ideally, he suggested, the Fed should follow a Taylor-type rule,
which prescribes changes in interest rates as inflation diverges from
target and/or the unemployment rate diverges from some presumed
“natural” level.

But Bullard said the Taylor principle “is violated when (inflation)
and (the output gap) are “too small.”

“In effect, the policymaker must be sufficiently aggressive in
responding to shocks, otherwise the economy will have multiple
equilibria, some of which may be very unpleasant,” he said.

Bullard said “one of the worst policies is to set both (inflation)
and (the output gap) to zero,” because “this guarantees that the Taylor
principle is violated, and that multiple equilibria exist.”

“This is also known as the ‘interest rate peg’ policy, because
interest rates never change,” he added.

Bullard suggested the U.S. is perilously close to just such a
policy and that it could have bad consequences.

“Actual policy rates in the U.S. have been near zero since December
2008 and are projected to remain there until late 2014,” he observed.
“This could be viewed as an approximation to the ‘interest rate peg’
policy, and thus conducive to multiple equilibria.”

Beginning in January, the Fed set a 2% inflation target, following
in the footsteps of foreign central banks.

Bullard said “inflation targeting is perfectly consistent with the
Fed’s dual mandate.”

What’s more, he said, “Naming an explicit numerical inflation
target is neither hawkish nor dovish. 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.”

** MNI **

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