The Fed's Mission: A Rocket Launch From Jupiter
Over the past couple decades, the Bank of Japan has tried time and again to get interest rates up from zero, only to discover that the zero bound has a peculiarly strong gravitational pull. Although I hope the new measures it announced this week will help, its past experience holds an important lesson for central banks everywhere.
When interest rates are already near zero, everyone knows that the central bank can’t do a lot more to fight adverse shocks. The sense of vulnerability makes any fear of a downturn more likely to become self-fulfilling, as people and businesses cut back on spending. With this constant drag of downside risk, escaping the zero lower bound is like trying to leave Jupiter instead of Earth: The economic rocket has to go a lot faster.
The metaphor is relevant for the U.S. Federal Reserve. True, the Fed lifted off from its self-imposed quarter-percentage-point lower bound last December. But that's nothing more than igniting the rocket. It must pass through many phases before the launch can be called successful.
The Fed showed little appreciation for the gravitational pull of the lower bound after its latest policy-making meeting this week. In the economic projections that accompanied Wednesday's interest-rate decision, a full 14 of 17 officials indicated that a further rate increase in 2016 would be appropriate -- at a time when they expect the inflation rate to be 1.3 percent, well short of the central bank's 2-percent target. Chair Janet Yellen said that the Fed would not wait to see the “whites of the eyes” of inflation before its next rate increase, suggesting that a balanced risk of overshooting or undershooting the target would be enough.
The Fed's approach would make sense if it were trying to launch the U.S. economic rocket from Earth. Launching from Jupiter, by contrast, requires waiting until the economy’s engine is generating more momentum. Specifically, the Fed should see the risks of overheating the economy as clearly to the upside. Core inflation should be back at 2 percent. Longer-term inflation expectations should be rising back toward historical levels, or even higher.
The Fed has indicated that it wants to raise rates more gradually than in any tightening cycle of the past 30 years. It should instead hold off until economic conditions are so strong that it needs to raise interest rates rapidly -- at least as fast as in 2004, or even as fast as in 1994. The Fed can't expect to crawl away from Jupiter. It will escape the gravitational pull of the zero lower bound only on the back of a forceful economic expansion.
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