There may not be as much slack in the U.S. economy as many forecasters believe, which means medium-term inflation risks could be higher, a Federal Reserve official said on Sunday.
In excerpts of remarks prepared for delivery at an economics conference, St. Louis Federal Reserve President James Bullard said it was hard to accurately measure the gap between what the economy is producing and its full potential.
"I am concerned about a popular narrative in use today — the narrative being that the output gap must be large since the recession is so severe," he said. "And so, any medium-term inflation threat is negligible, even in the face of extraordinarily accommodative monetary policy. I think this narrative overplays the output gap story."
He said calculations aimed at measuring the output gap do not take asset price bubbles into consideration, so if much of the current drop in output was tied to the bursting of the housing bubble, "then today's output gap would be smaller than it appears," which would mean a higher risk of inflation.
Bullard also said the Fed's $1.75 trillion asset purchase program was adding to uncertainty in financial markets because it was unclear how the central bank might adjust it as economic conditions change.
He proposed establishing something akin to the Taylor rule, which calculates the ideal interest rate for a given set of economic conditions, for asset purchases so financial markets would have a clearer sense of policy direction.
"Good policy means that the Fed needs to communicate to the private sector how it intends to react to shocks in the future," Bullard said.
"There has been little indication of how or whether these (asset purchase) amounts might be adjusted given incoming information on economic performance. This lack of clarity has created uncertainty in financial markets."
