St. Louis Fed’s Bullard Discusses “The Initial Response to the Inflation Shock of 2021”

ST. LOUIS – Federal Reserve Bank of St. Louis President James Bullard presented “The Initial Response to the Inflation Shock of 2021 (PDF)” at a meeting of the CFA Society St. Louis on Thursday.

Bullard told the society that the U.S. pandemic recession ended 20 months ago, and that U.S. real gross domestic product (GDP) has more than fully recovered and labor market performance continues to improve. However, he added that there was a significant unanticipated inflation shock in the U.S. during 2021.

“With the real economy strong but inflation well above target, U.S. monetary policy has shifted to more directly combat inflation pressure,” he said.

Pandemic risk remains, Bullard added, but omicron variant cases are expected to subside in the weeks ahead.

U.S. Real GDP Has Fully Recovered

Bullard noted that the U.S. is currently in the expansion phase of the business cycle. “National income is higher than it was at the previous peak and is poised to grow at an above-trend rate,” he said.

Bullard added that labor markets are very robust, according to key metrics. He noted that the labor force participation rate (LFPR) is sometimes cited as a relatively weak aspect of current labor market performance. “However, the LFPR has been on a downward trend since 2000 and is not currently unusually low, once the trend is taken into account,” he said.

He also noted that the LFPR is not robustly correlated with a rising standard of living in the U.S. data, suggesting that changes in the LFPR are not indicative of changes in the standard of living.

An Inflation Shock in 2021

Bullard explained that the inflation forecast in the December 2020 Summary of Economic Projections indicated that the median Federal Open Market Committee (FOMC) participant thought 2021 inflation would be 1.8% for both core and headline PCE inflation, which is below the FOMC’s 2% target.

Measured from a year ago, headline PCE inflation is currently 5.7% and core PCE inflation is 4.7%—well in excess of the 2% target, he said. This is the highest inflation in more than 30 years for both measures, he added.

The Monetary Policy Response

At the time of the pandemic recession, the FOMC moved the policy rate to near zero and began large outright purchases of Treasury securities and agency mortgage-backed securities—policy settings that largely remain intact today, Bullard pointed out.

However, the FOMC recently agreed to phase out asset purchases by mid-March and also penciled in more policy rate increases for 2022 than previously anticipated, he said. He noted that these steps have had an impact on financial market pricing, according to recent trading, as 2-year and 5-year Treasury yields have increased about 50 basis points in the last 90 days or so.

Bullard said the FOMC took steps at the December meeting to be in a better position to control inflation over the forecast horizon if inflation does not naturally moderate as much as currently anticipated. “Asset purchases will come to an end in the months ahead, but the FOMC could also elect to allow passive balance sheet runoff in order to reduce monetary accommodation at an appropriate pace,” he said.

“The FOMC could begin increasing the policy rate as early as the March meeting in order to be in a better position to control inflation,” Bullard added. “Subsequent rate increases during 2022 could be pulled forward or pushed back depending on inflation developments.”

Pandemic Risk from the Omicron Variant

In discussing the COVID-19 omicron variant, Bullard noted that it is becoming dominant in the U.S. and Europe, and that confirmed cases are rising dramatically. However, confirmed cases in the U.S. are projected to follow the pattern where the variant was first identified, in the Republic of South Africa, where cases peaked in recent weeks and have been falling since, he said.

Implications for Current Monetary Policy

Bullard pointed out that U.S. inflation “has surprised substantially to the upside” in an environment where measures of real economic activity and labor market performance are expected to remain robust. “There has been an initial U.S. monetary policy response to the inflation shock, and this response is already reflected in financial market pricing,” he said.

“The FOMC is in good position to take additional steps as necessary to control inflation, including allowing passive balance sheet runoff, increasing the policy rate, and adjusting the timing and pace of subsequent policy rate increases,” Bullard said.