Good Luck Drawing Conclusions About Monetary Policy

The Fed experimented a lot in the Great Recession. No one is sure if it worked.

OK, but did it work?

Photographer: Mark Wilson/Getty Images

With the U.S. economy mostly recovered from the Great Recession, arguments about monetary policy have died down a bit. But the lessons of the slow recovery are still percolating through the economics profession. The years 2008 through 2014 saw some monetary experiments that were unprecedented in the U.S. -- a long period of zero interest rates, several versions of quantitative easing, new types of forward guidance and the payment of interest on excess reserves. Although these experiments give us a lot of new information, the lessons are not clear, and continue to provoke spirited debate.

One of the most interesting debaters is Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis. Kocherlakota became famous for switching his outlook on macroeconomic policy -- once among the most hawkish of the inflation hawks, he now wants to use easy monetary policy to boost employment. Kocherlakota has recently begun to make his thoughts known on Twitter, and has started blogging as well.

Kocherlakota’s main argument is that Fed policy with rates at 0.50 percent is too tight right now. Not only does he fear that this is keeping people out of work, but he also worries that the Fed is sacrificing its credibility. Although the official target for inflation is 2 percent, it is raising interest rates even though inflation expectations are well below the target. That could convince the public that the Fed is being disingenuous about its inflation target -- that it regards 2 percent as a ceiling on the acceptable rate of inflation, rather than the target to aim for. Credibility is very important for the Fed; if the public stops believing that the Fed means what it says, then future efforts to combat deflation, or even inflation, might be much harder.
QuickTake The Fed Lifts Off

That should be fairly uncontroversial. Even if you believe -- as a few macroeconomists still do -- that the Fed can’t really affect unemployment, you probably still want the Fed to be transparent and maintain its credibility as a stabilizer of prices. However, Kocherlakota’s case rests on a big hidden assumption -- monetary policy has to work the way mainstream macroeconomists think it does.

Most macroeconomists think that lowering interest rates -- or promising to keep them lower for longer -- raises the rate of inflation. Everyone from Milton Friedman to the New Keynesians believes in this basic idea. But recently, the notion has come under fire from a group of economists called Neo-Fisherians (a term I actually coined, but which they have now adopted), who say that low interest rates actually cause low inflation, at least in the long run.

Steve Williamson, one of the original Neo-Fisherians, uses this idea to criticize Kocherlakota. If we really want to hit a 2 percent inflation target, Williamson and his fellow-travelers say, we shouldn’t cut the nominal interest rate -- we should raise it to 2 percent and keep it there. Although Kocherlakota himself was one of the first to suggest the Neo-Fisherian idea, back in 2010, he now disavows it, and he and Williamson have engaged in vigorous debate.

Actually, this debate is interesting, because the two sides should really be agreeing on policy. Neo-Fisherians like Williamson are generally inflation hawks, and would probably not mind if inflation stayed around 1 percent forever, or even lower -- and they believe that keeping interest rates low will accomplish this. Monetarists like Kocherlakota would rather try to boost employment, and keep inflation around 2 percent -- and they believe that keeping interest rates low will accomplish this! So although they disagree over theory, they should agree on keeping rates low.

The more important point, though, is that no one really knows what is going on with monetary policy right now. No one knows what the Fed is really trying to accomplish, or what it can accomplish, or how to go about accomplishing it. Is it still set on raising interest rates in order to avoid the semblance of abnormality from keeping them close to zero? Is it worried about demand-side shocks from China’s slowdown? Does it want the public to think that it will never let inflation go above 2 percent, or does it want us to think that 2 percent is in the middle of the acceptable range? Is it trying to raise inflation and failing? And if it did want to raise inflation to 2 percent, would it do so by keeping interest rates low, or by raising them?

It’s becoming clearer that the Fed's experiments during the Great Recession, dramatic as they were, taught us little about how monetary policy works.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.