James Bullard on the FOMC’s progress
Claiming that the FOMC is closer to the goals its dual mandate prescribes, James Bullard shared a measured perspective at the Tennessee Bankers Association’s annual meeting in Palm Beach, Florida, on June 9, 2014.
According to Bullard, we can measure the economy’s distance from the FOMC’s goals with the following simple objective.
Distance from goals = (i – i*)^2 + (u – u*)^2
In this equation, i is the current rate of inflation, i* is the target rate of inflation (both in percentage points), u is the current unemployment rate, and u* is the long-run average unemployment rate. The function assigns equal weights to inflation and unemployment. To evaluate, Bullard suggests setting i* equal to 2, which is the FOMC’s long-run inflation target, and i equal to the year-over-year PCE headline inflation rate. For the target unemployment rate, u*, Bullard takes 5.4, which is the midpoint of the central long-term range of 5.2% to 5.6%. Lastly, u is set to the current unemployment rate.
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The desired effect
The graph above shows how the function is now gradually approaching the levels it was at before the credit crises. The FOMC’s measures sure seem to be having the desired effect, especially in terms of attaining the FOMC’s dual mandate goals.
For instance, the subprime mortgage crisis, which was a result of Americans with the poorest credit being lent money to purchase houses they couldn’t afford, affected the U.S. economy badly. On the eve of increasing defaults, markets went dry of credit. Broad market ETFs like the SPDR S&P 500 (SPY) and the iShares S&P 100 (OEF), real estate ETFs like the Vanguard REIT Index ETF (VNQ), and banks like Citigroup Inc. (C) and Bank of America (BAC) all saw their prices slump. An immediate need arose for liquidity in the markets. The Fed stepped in to provide the necessary liquidity by initiating its quantitative easing program.
Though Bullard used the function above to assess the FOMC’s distance from its goals since 1960, the resulting graph (above) also highlights how the FOMC’s objective function value reacts to major macroeconomic events. The next part of this series sheds light on this important topic.