Is Fed Policy Based Upon A Faulty Estimate Of Potential GDP?

This article goes into detail on the recent speech by the President of the St. Louis Fed, James Bullard. I posted responses to his speech previously, but this is a more detailed description of his speech and its implications. Bullard does not like the current Fed policy of maintaining interest rates close to zero until 2014. The policy is based on the notion that GDP is tracking below a trend line extending from 2007. The difference between actual GDP, and the level of GDP on the trend line, is called the output gap. Bullard gives his reasons for believing that the trend line over-estimates the level of GDP that would exist if all of our resources were used. Therefore, Fed policy is based upon an exaggerated estimate of the output gap. We over-estimate the output gap because it does not reflect the loss of housing wealth that has occurred. That shock should permanently lower our estimate of potential GDP. He would rather have Fed policy based upon achieving the target inflation rate of 2%. That target is at risk as long as the Fed believes that the risk of inflation is low when we have a large output gap. He also argues that Fed policy may have a negative affect on aggregate demand. Current Fed policy reduces the level of interest income that would otherwise be available to savers for consumption.

This article provides an excellent summary of the reasons why Bullard's claim that we have suffered a permanent reduction in potential GDP is faulty. In fact, the data show that savings are in excess of investment demand at current interest rates. They would have to be even lower to absorb the excess savings. He is also criticized for using the decline in real estate values in his argument for permanent reduction in potential GDP. Housing is not regarded as productive capital in the construction of potential GDP. The loss of housing wealth has had an effect on aggregate demand and policy is correctly focused on increasing aggregate demand.