The Fed's Fear of the Unknown
Macroeconomic policy making is fascinating to watch. Here we have some of the most intelligent, competent, serious people in the world, acting in an environment of radical uncertainty. The Federal Reserve and all of the economists who staff it and advise it are basically groping in the dark.
For example, the Fed is wrestling with whether to raise rates this month or in those that follow. To make this decision, it must consider:
1) Which macroeconomic theory (or theories) to believe in.
2) How strongly to believe these theories.
3) How important economic growth is.
4) How important financial stability is.
5) How important inflation is.
6) How the Treasury will react to the Fed's decisions.
7) How other events in the world, such as the China slowdown or the Greece debt mess, will play out.
This is a complicated problem in the best of times. Just choosing which macroeconomic model to rely on is a daunting task. For decades, most economists believed that higher interest rates slow the economy and reduce inflation, while low interest rates encourage inflation and give a boost to growth. But that view is being challenged by a theory called Neo-Fisherism, which says that raising rates will actually boost inflation in the long run. That theory is far from the mainstream, but it is gaining credence because of the persistent failure of Japanese and U.S. quantitative easing programs to boost the inflation rate to central banks' long-term targets.
This and many other theoretical controversies mean that no one really has a firm grasp of how monetary policy works -- much less what we should do with it.
It's small wonder, then, that monetary policy makers sound a bit hesitant and confused. For example, a speech by Fed Vice Chairman Stanley Fischer at the recent Federal Reserve Bank of Kansas City Economic Symposium in Jackson Hole, Wyoming, seemed to express a high degree of uncertainty on a number of topics.
Mark Thoma, a University of Oregon economist and blogger, cut Fischer's speech into a simulated "interview" in which the vice chairman's remarks seem not to offer a cohesive case for a rate hike. Fischer acknowledges that inflation has been below the Fed's 2 percent target for years, and that inflation expectations have been stable. He also points to persistent slack in the labor market -- unused resources that are thought to hold down inflation. He mentions the deterioration in Chinese economic growth.
Yet despite these factors, Fischer insists that the Fed's chief objective is the "normalization" of interest rates -- i.e., raising rates above zero:
To do what monetary policy can do towards meeting our goals of maximum employment and price stability, and to ensure that these goals will continue to be met as we move ahead, we will most likely need to proceed cautiously in normalizing the stance of monetary policy...
With inflation low, we can probably remove accommodation at a gradual pace. Yet, because monetary policy influences real activity with a substantial lag, we should not wait until inflation is back to 2 percent to begin tightening.
Fischer seems reluctant to raise rates immediately, citing reasons that many others have pointed out. But the mere fact that he has to make that case, and that he accepts the idea that monetary policy must be "normalized" in a timely fashion, shows how fixated the Fed is on this idea.
Why the obsession with "normalization"? One possibility is that the Fed is afraid of expectation anchoring. If people get too used to zero interest rates, the economy may take a larger hit if and when the Fed eventually does raise rates. Another possibility is that the Fed is afraid of financial instability -- basically, that low interest rates encourage a reach for yield that produces excessive risk-taking and bubbles. Alternatively, Neo-Fisherian ideas might be making inroads into their thinking.
I have a different hypothesis. I think the Fed is just confused, and acting conservatively in the absence of knowledge. Zero interest rates are, historically speaking, highly unusual, and a prolonged period of zero interest rates is even more unusual. In this context, the Fed probably feels as if it is in uncharted waters.
A rate increase, therefore, at least moves the Fed back into a region where it can use past data as a guide to policy, since most of the historical record includes periods when interest rates were higher than zero. When you're groping around in a dark room, you instinctively want to make your way to the section of the room whose layout you know best.
That, in a nutshell, is my theory of why Fed officials keep using the word "normalization." Their goal is normality. They are drowning in radical uncertainty, and looking to reduce that uncertainty by whatever means they have at their disposal. It makes sense that even the world's smartest economists are scared of the unknown.
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