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James Bullard, the President and CEO of Federal Reserve Bank of St. Louis, discussed output gap, inflation targeting and cost of near-zero interest rates in his speech, Inflation Targeting in the USA.

This article looks into his opinion, which I consider to be right. As such, the conclusion is that near-zero interest rates can spell disaster in the long-term for the USA.

I had discussed the output gap trap for policymakers in one of my earlier articles. Mr. Bullard has the following opinion on the output gap:

The recent recession has given rise to the idea that there is a very large "output gap" in the U.S. The story is that this large output gap is "keeping inflation at bay" and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States.

Very clearly, Mr. Bullard is suggesting that artificially low interest rates for a prolonged period can lead to high inflation as a large output gap can't be used as an excuse to keep interest rates lower.

The reason for not considering output gap as an indicator to keep interest rates low is explained by Mr. Bullard:

The key to the large output gap story is the use of the fourth quarter of 2007 as a benchmark for where we expect the economy to be today. The idea is to take that level of real output, assume the real GDP growth rate that prevailed in the years prior to 2007, and project out where the "potential" output of the U.S. should be. By that type of calculation, we are indeed stunningly far below where we should be, perhaps 5.5 percent below, using data through the fourth quarter of 2011. What is more, we have made little progress in closing the gap defined in this way, because real GDP has only grown at modest rates since the recession ended in the summer of 2009. And furthermore, using current GDP forecasts from, say, the Blue Chip consensus, we have little prospect for closing the gap any time soon.

Is this really the right way to think about where the U.S. economy should be? I do not think it is a defensible point of view. Let me give you some of my perspectives.

Most analysts seem to agree that the middle part of the 2000s was characterized by a "bubble" in the housing sector. Housing prices were high and rising fast compared to nominal GDP. It is not prudent to extrapolate a bubble into the indefinite future and claim that such a calculation provides a good benchmark. Yet, that is what we are doing when we extrapolate fourth quarter 2007 real GDP. Furthermore, we normally have the good sense not to do this in other economic situations.

What Mr. Bullard explains here is that using the GDP or GDP growth as a benchmark when economic activity is at its peak is not a great idea. This is especially true when economic activity is being driven by a bubble or multiple bubbles.

To put things into perspective, Mr. Bullard gives a simple example, which will make the above explanation clear for readers.

Think about the tech bubble of the late 1990s and early 2000s. The NASDAQ index peaked at about 4800 on a monthly average basis in March 2000. In the month just passed, January 2012, it averaged about 2744, which is 57 percent of its peak value. In fact, with the type of calculation usually done for real GDP, which extrapolates growth rates, the NASDAQ would be miles below its "potential." Of course, most observers and market participants do not say that the NASDAQ is far below its potential value today. Instead, most say that there was clearly a bubble in the NASDAQ during the late 1990s and early 2000s, and that today's valuations are more sensible than the ones that were in vogue during the bubble period. When I put the case this starkly, I think many would agree that establishing a benchmark by extrapolating from the previous peak of a variable, when that variable was clearly influenced by a bubble, is a mistake. It gives a distorted view of the situation.

Therefore, keeping interest rates low using high output gap as an excuse is flawed policymaking. Inflation might not be terribly high at this point of time. However, over an extended period, surprise inflation can impact households and businesses.

Mr. Bullard also discusses on the cost of near-zero rates for an extended period.

But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.

In particular, the lengthy near-zero rate policy punishes savers in the economy. Because of life cycle effects, most of the asset holding in the economy is done by older Americans. Recent readings from the TIPS market suggest a 10-year real rate of return of minus 30 basis points or so, and a five-year real rate of return of about minus 120 basis points. These are extraordinarily low-substantially negative-real rates of return over very long time scales, and they are driven in part by FOMC policy.

These low rates of return mean that some of the consumption that would otherwise be enjoyed by the older, asset-holding households has been pared back. In principle, the low real interest rates should encourage younger generations to borrow against their future income prospects and consume more today. However, this demographic group faces high unemployment rates and tighter borrowing constraints, which may limit its ability and willingness to leverage up to finance consumption.

Consequently, the consumption of the older generations may be damaged by the low real interest rates without any countervailing increase in consumption by other households in the economy. In this sense, the policy could be counterproductive.

Conclusion

It is pleasing to see someone from the policymakers talking about the perils of low interest rates and the point that near-zero interest rates do more harm than good. Further, looking at the output gap to make policy decisions is also a fatal error for the long-term.

Having said this, I am convinced that one opposing stand won't help and policymakers will continue to pursue the current policies, which would set the stage for a bigger crisis in the long-term.

Near-zero interest rates would mean that investors need to speculate or invest in riskier asset classes to beat inflation. As such, equities and commodities will do well in the medium to long-term. Further, precious metals would continue to do well over the next decade and it would not be surprising to see gold clocking another decade of robust returns. Amidst all this, policymakers will continue to pursue expansionary monetary policies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: James Bullard On Why Fed's Policy Is Flawed