Fed risks disaster if ignores harm done by housing bust: Bullard

SOUTH BEND, Indiana (Reuters) - The U.S. central bank would be courting disaster if it pursued a so-called nominal growth target that did not take into account the economic damage done by the housing crisis, a senior Federal Reserve official warned on Thursday.

James Bullard, president of the St. Louis Federal Reserve Bank, also argued that the only variable in the economy the Fed could control over the longer term was inflation, saying it did best when focusing solely on that goal.

Bullard, in a lecture at the University of Notre Dame in Indiana, said the pre-crisis housing bubble had driven U.S. growth to levels that were not realistic to try to recapture. He cited work by economists Carmen Reinhart and Kenneth Rogoff that argue recoveries after a severe financial crisis are much slower.

"Attempting to target nominal GDP without adjustment for the Reinhart-Rogoff effect could be an unmitigated disaster," Bullard said during his presentation.

Frustration with a slow decline in high U.S. unemployment has sparked calls by some economists for the Fed to target nominal GDP, which measures growth in output before adjustments for inflation. They argue this would help communicate a powerful commitment to do whatever it takes to restore growth to its pre-crisis levels.

The Fed last week announced an aggressive plan to buy $40 billion of mortgage-backed bonds every month until it saw a substantial improvement in the outlook for the labor market.

Bullard, who is not a voting member of the Fed's policy-setting committee, told Reuters in an interview on Tuesday that he did not agree with the action. He said he would have dissented had he had a vote, because he would have favored seeing clear evidence the economy was slipping and risked another recession before launching the plan.

U.S. unemployment was 8.1 percent last month and economic growth remains stuck around 2 percent, despite cuts in the Fed's target overnight interest rate to near zero and massive bond purchases. The bond purchase caused the Fed's balance sheet to balloon to $2.3 trillion, even before last week's news.

POLICY LIMITS

Bullard, who expects U.S. growth to be above 3 percent in 2013, said price levels were the only economic variable the Fed could control over the longer term. But he allowed that the Fed has "room to maneuver" on price pressures at the moment, since inflation was near its 2 percent target.

"If you want to fix the Reinhart-Rogoff shock, which is a real phenomenon, you probably have to do other things ... we need other types of policies, not just monetary policy," he said during a separate discussion with reporters.

Fed Chairman Ben Bernanke has repeatedly said that there are limits to what monetary policy can achieve and has urged U.S. lawmakers to use fiscal policy to spur economic activity in a more direct, targeted fashion than the central bank can manage.

Looking at inflation rates since the mid-1990s, the Fed has done a good job of keeping inflation around 2 percent, and since the crisis of 2007-2009, it has continued to do a good job, Bullard said - underlining his sense that the latest policy measures were not warranted.

"What we did looks pretty close to optimal," he told students, faculty members and guests.

Arguing the shock had likely done severe damage to the U.S. economy, Bullard said growth before 2007 had probably been artificially high because of the boom, and had now down-shifted as people try to work off the housing debts they ran up.

"After 2009 we've got all this extra debt in the economy ... people are deleveraging," Bullard said, noting the U.S. economy grew at an average of 2.8 percent a year between 2003 and 2008, but only at 2.2 percent since 2009.

However, this rate of growth looked about right, considered in the light of the reduced capacity of the post-crisis economy.

"The aggregate price level seems to be right about on target. Real GDP, on the other hand, seems to be markedly influenced by the Reinhart-Rogoff effect," he said.

(Reporting by Alister Bull; Editing by Leslie Adler and Mohammad Zargham)

Source: http://news.yahoo.com/fed-risks-disaster-ignores-harm-done-housing-bust-030325148--business.html

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