Fully Understanding Bullard’s Brake on the Relief Rally

Recently, the hawkish remarks by James Bullard, president of the Federal Reserve Bank of St. Louis, have drawn a great deal of attention.

His comments, which again raised the possibility that the terminal rate could be higher, poured cold water on the market’s rebound rally.

The bottom line is that his remarks were hawkish, but it is still worth taking a closer look at exactly what Bullard said and how the whole story unfolded.

At an event hosted by Greater Louisville, Bullard began his presentation with a slide deck titled “Getting into the Zone.”

He noted that inflation is currently far above the FOMC’s 2% target,

and that bringing it back to target would require both balance sheet reduction and a substantial increase in interest rates.

He argued that while past rate policy has affected inflation, its impact has been limited, and that disinflation — a decline in inflation — is not likely to arrive until 2023.

For now, he said, additional rate hikes are still needed.



He then moved on to discuss what would constitute an appropriate level for interest rates.

This is the part that many media outlets and investors seized on in calling Bullard’s remarks “quite hawkish.”

In its most recent statement, the FOMC said it would continue raising rates in order to reach a “sufficiently restrictive” level.

Bullard went on to say that this sufficiently restrictive level — the appropriate policy rate —

would be around 5% if you judge policy as relatively accommodative under the Taylor rule,¹ and could reach about 7% if you assume a less accommodative stance.

His comment that “even under an accommodative specification, the current policy rate is not yet sufficiently restrictive” understandably came across as very hawkish.

Looking at the slides, what Bullard is really saying is:

given current economic conditions, a 5% policy rate is not enough, and the Fed has to leave the door open to something closer to 7%.

Taylor rule¹: A guideline for setting the nominal policy rate proposed by John Taylor in 1993. The rule sets the interest rate based on inflation and output; under the rule, a 1 percentage point rise in inflation should be met with more than a 1 percentage point increase in the nominal policy rate.

In fact, the specific rule Bullard presented was as follows.

* x is a coefficient that reflects how strongly policymakers respond to deviations of inflation from target,

and it is included to account for the fact that, because macro data are backward-looking, an overly aggressive response could create headwinds for the economy.

Bullard specifies that he uses a value of 1.25 for an accommodative case and 1.5 for a less accommodative case.

Using the FOMC’s Summary of Economic Projections (SEP) and Congressional Budget Office (CBO) data, he estimates the output gap² and finds that

actual growth is running above potential. As a result, the red term in the formula is effectively ignored (set to zero).

Output gap²: The difference between real GDP growth and potential growth. When real growth exceeds potential, it creates inflationary pressure; when potential exceeds real growth, it exerts deflationary pressure.

In markets, this “possibility of going up to 7%” clearly landed with considerable force.

That is because Bullard’s subsequent comments made it clear he was not joking.

Bullard noted that even after this year’s rate hikes, financial stress in the economy remains very low,

and argued that, given today’s very high inflation, the Fed’s rate increases have been appropriate.

He did say that the “risks from higher rates” are being weighed against “the benefits of bringing inflation back to 2%,”

but his basic stance is that, for now, there is still room to raise rates further without causing serious problems.

He was not uniformly hawkish throughout the presentation, however.


He also noted that if inflation declines over the coming months, the recommended policy range would move lower as well.

In other words, his 5–7% target range for rates could be revised down at any time.

He also made clear that his view of the appropriate rate lies somewhere between the “accommodative” and “less accommodative” cases.

The appropriate rate is determined separately depending on whether inflation is above or below the target level R* (the neutral rate),

and the inflation measure he uses is PCE inflation. Headline PCE inflation is running above 6%, but he does not plug headline PCE into the rule.

Instead, he focuses only on core PCE inflation and the Dallas Fed’s trimmed mean PCE inflation.

Under the Taylor rule, the policy rate is set above the inflation rate,

so using core and trimmed mean PCE — roughly 1 percentage point lower than headline PCE — keeps his specification from sounding overly hawkish.

“Depending on whether you plug consumer price inflation, core inflation, or the GDP deflator into the inflation term³, you will get a different policy rate.”

“The weights assigned to the inflation gap and the GDP gap can also differ.”

If you recall the issues Ben Bernanke raised with the Taylor rule, which he discussed in detail here, Bullard’s framework could easily have produced much higher rate prescriptions.

That is likely why Bullard chose to describe the second case as “less accommodative” rather than “tight.”

Inflation term³: In the standard Taylor rule, “appropriate policy rate = equilibrium real rate + inflation + 0.5 × (inflation gap) + 0.5 × (GDP gap).”

The version of the Taylor rule introduced by the Fed for the US is: “appropriate policy rate = real rate + target inflation + (tolerance for inflation deviations + tolerance for output deviations) × (core inflation – target inflation).”

Finally, Bullard emphasized that the purpose of his presentation was to identify an appropriate level for rates,

and that it did not attempt to model the inertia that would follow once policy decisions are actually implemented.

If inflation were to fall quickly, the Fed could pivot back to a more accommodative stance just as quickly.

There is now just about a month left until 2023, and Bullard expects inflation to start declining from 2023 onward.

But we should remember that for the past 18 months, both markets and the FOMC’s SEP have repeatedly forecast that inflation would soon come down.

Forecasting the macroeconomy is genuinely difficult, and this is no time to let our guard down.

In three lines:

1. Bullard’s estimate of the appropriate policy rate is in the 5–7% range.

2. However, he also said this range could be revised down at any time, and that if inflation falls quickly, the Fed’s stance could shift just as quickly.

3. Bullard expects inflation to be under control in 2023, but given that both markets and the SEP have been predicting disinflation for the past 18 months, it is still too early to relax.