This article first appeared in the St. Louis Beacon, Aug. 27, 2009 - In his quiet, measured way, James Bullard, president of the Federal Reserve Bank of St. Louis, is talking these days -- to students, consumers and media types -- about how a careful monetary policy will help nurse the nation's sick economy into recovery.
First, we dodge deflation, and then we put a lid on inflation.
Of course, his explanation is much more detailed and complicated than that, but he seems willing to take the time to share it.
And he's also sharing a hint of optimism about the economy, based on signs that the housing market has finally hit bottom and that the nation will see slow economic growth in the third and fourth quarters. On the other hand, he acknowledges that with an unemployment rate of 9.4 percent, the job market is still very poor.
"I do think there have been some signs of improvement, just in the last few weeks and months here,'' said Bullard, who oversees the Fed's Eighth District, headquartered in St. Louis, with branches in Little Rock, Louisville and Memphis.
"The unemployment claims have come down a little bit, off their peak. They're still at very high levels, but they have started to drift down. I think that's encouraging. We're still losing a lot of jobs each month. It has been slowing, and so hopefully we'll get to zero here during the fall. But labor markets tend to lag. There is no question that employers feel very nervous about how the economy is going to perform.''
Bullard, 48, joined the research division of the St. Louis Fed in 1990, taking office as president on April 1, 2008, just months before the nation woke up to its worst financial crisis since the Great Depression.
Bullard served as deputy director of research for monetary analysis under his predecessor William Poole, an experience that he says helped prepare him to represent the district on the Federal Open Market Committee, the Fed panel which sets interest rates. He will become a voting member of the committee next year.And his experience as a university professor -- he's taught economics at Washington University, the University of Missouri-St. Louis and Southern Illinois University-Edwardsville -- makes him well-suited for another role: educating the public about the nation's market system, monetary policy and the role of the Federal Reserve Bank. He believes that Americans should understand how their complicated economy works.
"As much as we try to communicate, it's abstract -- and it seems far away to people on a daily basis,'' Bullard said. "So we try as hard as we can to keep talking and to keep explaining what we do.''
And Bullard seems very open to explaining. On Wednesday, he welcomed the Beacon into the boardroom of the St. Louis Fed, where he shared his thoughts on a range of topics -- from economic recovery to the nature of greed.
On Thursday afternoon, he was scheduled to speak at the University of Arkansas, discussing monetary policy and the state of the economy and financial markets. Afterward, he planned to take questions from the public and media.
This past week, while attending an annual Fed economic symposium in Jackson Hole, Wyo., he talked policy with the Fox Business Channel and told a reporter from Reuters that he believes the economy is turning the corner. Bullard also suggested that the financial markets haven't fully "digested" the Fed's pledge to keep interest rates low, which means that they will stay low even beyond the time they might normally be raised. The Fed lowered its rates to near zero last December.
Bullard explains that it's all consistent with the Fed's current "accommodative" monetary policy aimed at alleviating strains in the economy and avoiding a deflationary trap, like the one Japan fell into during the 1990s. But, as economic conditions improve, he stresses that the Fed will have to begin unwinding the emergency programs it put in place to deal with the financial crisis.
The bottom line is that in order to avoid inflation, the Fed will need a careful exit strategy from what Bullard refers to as an "alphabet soup" of rescue programs.
Here are excerpts from the Beacon's interview with Bullard:
Recently, you've been talking about the timely steps the Fed must take to continue assisting the nation's economic recovery, even as some of the emergency programs it put into place are phased out.
BULLARD: The buzz word is "exit strategy," and I think the key part of that is strategy. It doesn't mean exiting today.
Today, we have a very accommodative monetary policy. We're doing all we can to try to support the economy when it's really down, and so far we haven't seen a positive GDP (Gross Domestic Product) growth number for four quarters. We're still losing jobs, as we sit here talking, so unemployment's very high. The economy is down, and we're doing all we can to be accommodating right now.
Having said that, markets are forward-looking so they care about what you are going to do over the next five years, and how that's going to affect today's pricing in the markets. They're saying what are you going to do three or four years from now, because that's going to affect how I'm going to price Treasuries today.
So that's why you have to have this strategy. You have to somehow lay out what's going to happen in the future because it's going to affect prices today. You don't want to have markets go off in some crazy direction where they say, "Oh, there's going to be a tremendous amount of inflation in the future, so therefore I have to price that in today.''
Clearly, that exit strategy is going to be critical -- and extremely delicate.
BULLARD: Unfortunately, the message on exit strategy is a complicated one because there are really three parts to monetary policy right now.
We have all these lending programs, it's an alphabet soup of lending programs: TALF (Term Asset-backed Securities Loan Facility), we have a commercial paper funding facility, we have swaps with foreign central banks, we have many other kinds of lending facilities. Those are all part of this ''lender of last resort'' function, and those were all designed to get a lot of liquidity out there in the market while there was a lot of panic in the market. That is a very traditional central bank response to a crisis. But as the crisis recedes, that all kind of naturally goes away. So, I wouldn't worry about those programs as far as inflation is concerned.
The second part is asset purchases. The asset purchase program -- we're just creating money and buying these assets -- most of them mortgage-backed securities issued by Fannie Mae and Freddie Mac. For that, the balance sheet is going up in a straight line. The monetary base is going up in a straight line. And before the program is over, we will have more than doubled the monetary base.
That could be viewed as possibly pretty inflationary going forward, and we have to be very careful about saying that we're going to withdraw that over the next few years, as the economy gets better, in such a way that we won't create a lot of inflation. That's going to be a tough call -- and that's laying out there in the future, but the intention is to pull that back in just the right way so that we don't get too much inflation going forward.
The third part is interest-rate policy. Interest rates are at zero or close to zero right now -- short-term interest rates -- and at some point we will raise interest rates. The thing we have said about interest rates is that we intend to keep them near zero for an extended period - a famous Fed phrase.
We voted in December of last year to go to near zero, so we've been there about six months. The idea of an extended period is that they'll remain low even past the point where you might think we'd start raising rates. Any rise in interest rates lies in the future because of this extended period language.
That's a complicated message about exit strategy because the response to the crisis has been multi-faceted and we're doing lots of things. You can't just say we're going to exit on such and such date -- it's more complicated than that.
Critics have said that the Fed contributed to the economic downturn by keeping interest rates too low for too long. What is your opinion on that?
BULLARD: It's a very common thing to say that the federal funds rate was too low for too long in the earlier part of this decade. I wasn't in this job, but if I had been in this job I would have wanted to raise rates sooner and somewhat faster than we did. But I don't think that all by itself that that would have solved all of our problems. Our problems really came from the securitization markets that went badly awry. It would have helped to have a little higher interest rates a little sooner, but it wouldn't have really fixed that problem, which was looming and growing during that period.
As a voting member of the Federal Open Market Committee next year, will you be taking a strong position on interest rates?
BULLARD: I will, but my opinion is that the actual voting isn't really that critical. I think every member -- there are 19 people on the committee if it's at full strength -- everyone talks at every meeting. Everybody contributes on every issue. It's basically a consensus organization. There are only rare dissents. The voting is not that critical. It could be, conceivably, that you'd have some issue where you'd get a sharp split and the vote would really matter.
I try to be outspoken, but I have found that there is no shortage of opinions on the FOMC. Everyone takes the job very seriously. They have very strong views, and they have very good arguments that they can marshal for their positions.
In your opinion, why didn't the Fed and other economic experts foresee the financial meltdown that led to this recession?
BULLARD: I've called this a failure of financial engineering, and the example I've used is asbestos.
Asbestos was thought to be a good product. In many ways, it is a good product -- it's a great fire retardant -- but it has these health side effects that weren't discovered until later. Then, you had lawsuits and all kinds of sick buildings over the nation. They all had to be meticulously cleaned out or torn down. Even tearing them down was a difficult project -- very expensive, very painful for everybody. That was an engineering failure.
And I think the failure of financial engineering is very similar in this instance.
There were securitization markets in the 1990s for prime mortgages. And they were fairly successful. This means you package a lot of mortgages together. You sell them as a package to investors. The financial engineering part is, yes, some people will default on their mortgages, but not everybody will default at the same time, so you'll get better risk properties with this package than you would by just holding the one mortgage.
Those were prime mortgages. Then they said, very logically, why don't we extend this to sub-prime borrowers? We're going to have to charge more because there are different risk profiles. This borrower might be more likely to default, but we can price that in, and then we'll still get the risk benefit of the fact that we're diversifying across the country. That was the idea.
So now you have these new securities, sub-prime mortgage-backed securities, or mixes of prime and sub-prime, and they said we'll price them right because we are taking extra risk here. And the first few years everything worked well, partly because housing prices were going up. Then everyone got confident in these securities, and they ballooned up to a trillion dollars or more. And now, you've got these things trading all around the world. All kinds of organizations are holding them, and they're thinking of them as a very trustworthy product.
Then, housing prices started going down, and you found these were flawed products. They had not been priced properly for the possibility that there would be a big downturn in housing prices nationally. These things weren't liquid anymore: "I can't sell them anywhere. I don't know how to value this product because I can't trace it back to all the individual mortgages, and I'm taking big losses on this. This is threatening my viability as an institution.''
I wouldn't really point fingers -- that one single person or one single entity was at fault for this. The truth is these were thought of as pretty good products initially and they made a lot of sense initially. And, like asbestos, it was only later that you figured out that these have some deep flaws that we didn't really realize.
Some people would say those "human flaws'' were greed.
BULLARD: But you're talking to an economist. You say to an economist, "It's greed." Well, it's all greed. People are self-interested, and they follow self-interested behavior. The guy who's running your favorite restaurant, well, I suppose he's greedy in some sense because he's running the restaurant for a profit, but you go there because he's producing fantastic meals that you like to eat. And it's a mutually beneficial trade; he gets to make his living and you get to eat a great meal. That's all greed. To an economist the greed thing doesn't make any sense.
If people see products on shelves, and they see one that's cheaper and equally good they're going to take the cheaper product because they don't want to spend more than they have to. This kind of behavior is a constant all across the economy in all kinds of different situations. You start from that, and then you think about what went wrong.
The good side of greed is that it gives you a basic model of how people are going to behave. They're going to go for the cheaper product. They're going to look out for their own welfare. They're not going to buy products that they don't feel are that good. All of these behaviors come from the idea that there's self-interested behavior.
Or, fraud?
BULLARD: Fraud is fraud. A lot of times when people say greed they really mean fraud. Criminal behavior is criminal behavior, and that has to be prosecuted. There's no getting around that.
There are rules about how these things are supposed to be done, and if you're not complying with the rules -- that's fraud. And there are systems in place to try and root that out and to try to get prosecutions.
The use of asbestos, for the most part, has been banned. What about mortgage-backed securities?
BULLARD: You're going to have financial engineering in the future, and it's going to have to be done better, in the same way that you would want to build a fire-safe building even after you discovered asbestos isn't going to solve all of your problems.
Financial engineering is a great thing, in many ways, for the economy because you're figuring out ways to distribute risk in a more efficient way. That should be a great thing for everybody. And you should be able to get credit to people who might not otherwise get credit. But when you build these products, they have to be built on assumptions that meet the real-world test, and they have to be priced accordingly.
I think that all could have been done correctly. It wasn't. But you don't want to have the idea that, "Oh, because securitization didn't work out this time, and caused a lot of problems, that we're never going to do that." It should work, and it can be done a lot better and there are more things that can be done to improve these products.
In the meantime, some have called for the Fed to play a greater role in regulating financial institutions.
BULLARD: People are upset. I'm upset. Everybody's upset that all of this happened. The natural response is to say we need more people looking over other people's shoulders and making sure that they're doing the right thing. That's not the right image you should have about regulation. You cannot really say, "We're going to watch every loan that Citibank makes, and we're going to go down the list and 'X' out a couple of them that we think are too risky." That's a very labor-intensive and very unrealistic view of what regulation really is.
These firms all are trying to make money. They have their own incentives to control their risk-taking. And what you want to do is strengthen those incentives so they work better. They don't want to fail anymore than we want them to fail. But, on the other hand, incentives are somehow out of line, and you want to get them back in line so you get a system that works a lot better going forward.
Where does the Eighth District stand in terms of its economic health?
BULLARD: We certainly have not been spared, but we might be doing slightly better than the nation as a whole. One reason for that is compared to places like California or Florida, we did not have the huge housing bust that they had. Now, it is true that housing prices have come down all over, but it is a qualitatively different thing, I think, in California, than it is here. And California has higher unemployment as a result. They've been hit harder.
I do think we'll get positive GDP (Gross Domestic Product) growth in the current and in the fourth quarter. Some news was out today about housing sales going up quite a bit. So I think you are seeing the bottom in the housing market. Even if we hadn't had the panic in 2008, one of the things we were saying at the Fed, is that once the housing market bottoms that will help things a lot. That will allow people to price these mortgage-backed securities more accurately and not have to worry about further declines in housing prices. So I think you are seeing that bottoming out in the housing market, and that's very encouraging. It's bottoming out at a very low level, it's fallen like crazy.
What's driving the shift in the housing market?
BULLARD: I know what I think is happening. As the economy turns around, you've got a lot of people who stayed on the sidelines over the last two years. There was so much uncertainty. Prices were falling. They wondered if it was really a good time to buy a house. It's the kind of decision you can delay for a while. But if you've got a family and you want to get out of the apartment and into a house, you have to make a decision at some point. And I think there's been a buildup of people who have been on the sidelines and now they are probably saying, "OK, the economy probably will turn around here, and now it's time to come off the sidelines and buy these houses." We've been waiting for that effect for a long time, but I think that effect may be taking place now.
Obviously, you don't give people financial advice, but that probably doesn't stop them from asking you for it.
BULLARD: You're right -- I don't give any investment advice. But I will say one thing: There is so much focus on the stock market. Really, too much focus. It's very volatile day to day. I think you should average over longer periods of time.
What should the average consumer know about the Fed?
BULLARD: Interest-rate policy -- because that affects the rates on loans, the rates on mortgages and all kinds of credit decisions all through the economy. Maybe the average household isn't looking for a loan rate today, but if you are it's going to affect you.
I think the other aspect that has really come up in the last two years is the "lender of last resort" function of central banks. If there's a panic or a turbulent time period, and liquidity is a big problem, institutions come to the Fed -- and we do lend. And in this crisis we've lent on a grand scale, and that is part of the original design of the Federal Reserve.
During the famous panic of 1907, which I'm sure everybody knows, the U.S. didn't have a central bank and J.P. Morgan basically had to play this role himself. That would be like Bill Gates coming in during this crisis; I don't think even Bill Gates had enough money during this crisis.
One reason you want a central bank is to play this lender of last resort role. That function is a little more distant, I think, from the typical household, but you do want to have tools to get a panic under control.
You have said that you are concerned about even the appearance of political pressures being put on the Fed by, say, members of Congress.
BULLARD: Right now we're in an environment, where for a variety of reasons, the federal government's deficits are really, really high.
One of the things that can happen is that the U.S. Treasury issues the debt, and then the Federal Reserve buys the debt. That's called monetizing the debt. At some level, some monetization of the debt goes on all the time because the Fed does buy and sell Treasury securities all of the time. But if the perception got started that the Fed was just going to print money and buy this Treasury debt, that could be very inflationary. It's the kind of thing you see in the developing world -- where they say we're just going to print money to pay our bills. And you get a lot of inflation.
Now, of course the U.S. has tremendous credibility, and in some ways we can get away with this. If we were a developing country and we were running these kinds of deficits and this loose of a monetary policy we would not be able to get away with it. International investors would shy away from that country, pull away their investments, and the value of the currency would drop.
So, I've been worried about this. Even the perception that something like this was going on could be very dangerous for the U.S. I'm not the only one; many people are talking about this.
Of course, the Fed has a Treasury purchase program, where we said we were going to buy $300 billion of debt. Now, we're letting that expire in September or October. But if you're somebody from outside the country who doesn't understand the intricacies of American politics, and you're just seeing that the central bank is buying up a lot of the debt that the federal government is running up -- that looks like monetization. That looks like a lot of inflation.
About James Bullard
* Appointed president and CEO of the FederalReserve Bank of St. Louis in March 2008 and took office on April 1,2008. Bullard succeeded William Poole, who held the post for 10 years.
* Oversees the Fed's Eighth District, whichincludes eastern Missouri, southern Illinois, Arkansas and parts ofMississippi, Kentucky, Indiana and Tennessee. The St. Louis Fed is oneof 12 regional Reserve banks, along with the Board of Governors inWashington, D.C., that constitute the Federal Reserve System. The Fedserves as the nation's central bank and is responsible for supervisingbanks and setting monetary policy.
* Joined the research division of the St. Louis Fedin 1990, rising to the post of vice president and deputy director ofresearch for monetary analysis.
* Earned a bachelor's degree in quantitativemethods and information systems and economics from St. Cloud (Minn.)State University and a doctorate in economics from Indiana Universityin Bloomington.
* Bullard is a native of Forest Lake, Minn. He and his wife, Jane Callahan, have two daughters.
Source: The Federal Reserve Bank of St. Louis
