How a central banker's rate shift showed the way for Federal Reserve

RICHMOND, Virginia -- In mid-2016, even with unemployment falling and the economy growing modestly, James Bullard, head of the St. Louis Federal Reserve Bank, was concerned.

Months earlier, with Bullard's support, the Fed had raised rates for the first time in seven years. Panicky financial markets responded by sending stocks tumbling. The Fed delayed plans for further rate hikes. Through it all, there was still no sign of higher inflation -- the supposed bogeyman that had led the Fed to raise rates in the first place.

"We were expecting inflation to pick up," Bullard acknowledged in an interview this month. "We had the idea that we should be pre-emptive and prevent that from happening. But a lot of those predictions didn't come true. So that made me think that we didn't have the right framework."

Bullard decided to develop a new framework, which he announced in June 2016. It was based on a notion Bullard was among the first Fed officials to fully recognize: That the U.S. economy was stuck in a rut, with low growth and low worker productivity, and wouldn't likely spark high inflation even if unemployment kept falling.

It's a notion that members of the Fed's rate setting committee, including Chairman Jerome Powell, have come to collectively embrace. It helps explain why Powell has made clear, as recently as this week, that he sees no need to raise rates anytime soon despite an unemployment rate near a 50-year low.

Bullard's framework flew in the face of a long-standing belief among economists that as unemployment falls steadily, employers will keep raising wages and high inflation will follow. Casting aside such traditional economic models, Bullard felt that the economy could keep growing and employers could keep hiring without igniting inflation. He argued that the Fed would probably need to raise rates only once more, to a range of just 0.5% to 0.75%.

That view, highly unusual three years ago, transformed Bullard from a centrist member of the Fed's policymaking committee to one of the more dovish. ("Doves" typically worry less about inflation and more about sustaining growth and employment; "hawks" generally favor higher rates to control inflation.)

Most Fed policymakers at that time worried that the unemployment rate -- 5% in December 2015 -- was low enough it would likely accelerate wages and inflation. They wanted to lift the Fed's benchmark short-term rate closer to its historical norms after seven years of holding it at zero. The consensus then was that a rate as high as 3.5% would still be "neutral": That is, it would neither support nor restrain growth.

And yet since late last year, the Fed has shifted much closer to Bullard's position. Powell has engineered three rate cuts since July, to a range of just 1.5% to 1.75%. These cuts followed four rate hikes last year.

To a large extent, the U-turn reflected worries among Fed policymakers that President Donald Trump's trade war with China was weakening the economy and that this threat would worsen over time. The rate cuts were intended to offset that drag.

But Powell has also indicated that the policy switch occurred, in part, because the Fed has abandoned or revamped models that correlated low unemployment with high inflation. Most economists agree that this correlation has largely disappeared, at least for now. Online retail and price-conscious consumers have made it harder for many companies to charge more. And with labor unions a diminished force, workers can't push for higher pay so easily.

"There was a tight connection between unemployment and inflation," Powell told Congress this month. "That is no longer the case and really hasn't been the case for some time."

Key Fed officials have also suggested that the neutral rate, which the Fed thought was as high as 3% late last year, could be as low as 1%.

"That's what Bullard was saying way before," said Kathy Bostjancic, an economist at Oxford Economics. "He was kind of a thought leader on the Fed."

Many economists foresee another rate cut in 2020. If so, that would mean borrowing costs, like mortgage rates, would likely stay low for months or even years. This would help support consumer and business spending as well as the economy. It would also mean, though, that savers would earn little return on their bank accounts and other fixed-income investments.

"We just don't live in an inflationary world anymore," said J.W. Mason, an economist and fellow at the Roosevelt Institute.

Rather, the economy is more likely to face "chronic, ongoing weak demand" from consumers, Mason said. That's why the last three recessions have bred sluggish recoveries.

Bullard's new framework has led him to a more consistent approach to monetary policy, economists say. Before 2016, he had gained a reputation as indecisive, alternating between hawkish and dovish positions, said Tim Duy, an economist at the University of Oregon and longtime Fed watcher.

Bullard had taken office in April 2008, in the early days of the Great Recession, after serving as an economist at the St. Louis Fed since 1990. He is the third-longest-serving of the 12 regional bank presidents, behind Charles Evans of the Chicago Fed and Eric Rosengren of the Boston Fed.

Back in 2012, Bullard had embraced a hawkish position and opposed Chairman Ben Bernanke's decision to launch a third round of Fed Treasury purchases to try to lower longer-term rates and spur growth. Bullard said he wanted to wait until the direction of the economy became clearer.

Yet the next year, he opposed Bernanke's timing for winding down those purchases, citing a more dovish concern about still-low inflation.

One economic consulting firm cited Bullard as one of the most market-moving Fed officials, typically second only to the chair, because he was seen as a bellwether on the committee.

"I try not to be dogmatic," Bullard said in the interview.

Unlike all 16 other Fed policymakers, Bullard doesn't forecast a long-term target for the Fed's benchmark rate. He thinks it's too hard to predict the economy that far ahead.

Since 2016, with his new framework in hand, Bullard has stuck mostly to a dovish stance. He warned in 2017 that continued Fed hikes could cause short-term rates to exceed long-term rates -- an odd phenomenon known as a "yield curve inversion" and usually a precursor of a recession. The yield curve did invert in March this year, though it reversed last month.

Last year, Bullard wasn't a voting member of the Fed's rate-setting committee when it raised rates four times. But he said he accepted the first three and argued only against the fourth in December. That hike, along with signals that the Fed would raise rates twice more in 2020 and continue reducing its Treasury bond holdings, sent the markets into a tailspin.

"The Fed has seen more inflation out there in the future than the market has basically over the last 10 years," Bullard said. "We kept predicting ... that inflation was just around the corner and therefore we have to get rates higher. That has turned out to be wrong. And markets had it right."

Some other Fed officials have been pushing in the same direction, including Neel Kashkari of the Minneapolis Fed, who is considered even more dovish than Bullard. Lael Brainard, a member of the Fed's board of governors, gave a speech in 2016 about "the new normal" of lower rates and inflation.

Still, Andrew Levin, an economist at Dartmouth University and an adviser to former Chair Janet Yellen, said Bullard's approach shows how regional bank presidents can bring distinctive views to the Fed's policymaking, which otherwise is typically dominated by the governors based in Washington.

"It takes courage" to defy the consensus view, Levin said. "Bullard has exhibited that courage on multiple occasions over the years."