The Fed Shouldn’t Be Afraid of Growth
The Federal Reserve has intimated that it intends to keep pulling back on economic stimulus in 2017, both by raising short-term interest rates and by shrinking its holdings of long-term assets. These steps have little to do with controlling inflation. Instead, they are part of a systematically anti-growth approach that the Fed adopted four years ago -- an approach that should be abandoned as soon as possible.
Four years ago this month, Ben Bernanke (then Federal Reserve chairman) announced in congressional testimony that, if the economy continued to improve, the Fed intended to reduce (or “taper”) asset purchases aimed at bringing down longer-term borrowing rates. Since Bernanke’s announcement, the Fed has been tightening monetary policy. It ended the asset-purchase program and initiated a sequence of short-term interest rate increases.
Why has the Fed been tightening? Concern about inflation would be one plausible reason. But the shift in monetary policy occurred as inflation was falling. And, as the following chart shows, the tighter policy stance has served only to keep core inflation below the Fed’s 2 percent target:
The low inflation has also affected expectations of future inflation. Judging from interest rates on Treasury securities, for example, market participants are expecting the Fed’s preferred inflation measure -- the Commerce Department’s price index for personal consumption expenditures -- to increase at an annualized rate of about 1.5 percent over the next decade.
So for the past four years, the Fed has been tightening too quickly to achieve its inflation goal. Why? The answer, I think, is that it wants to keep the rate of economic activity from getting too high relative to what the central bank sees as the long-run sustainable level.
This may seem like a strange objective, given that Congress has charged the Fed with promoting “maximum employment,” which sounds like “try to make employment as high as you can.” But the Fed knows that if it pushes economic activity above its long-run level in pursuing that goal, it will eventually have to hit the brakes and bring growth below normal to cool the economy and keep inflation under control. The Fed doesn’t want to be in that position, so it gets just as worried when unemployment falls below its target as it does when unemployment is too high. 1 As a result, when the economy is close to what the Fed sees as full employment, the central bank takes a decidedly anti-growth policy stance to keep employment in check.
This approach might be defensible if the long-run level of economic activity was easy to know. Unfortunately, it’s not. In this decade, the Fed and other economic forecasters have been consistently surprised by how slowly potential output has grown. In the late 1990s, the opposite happened, as technological innovation expanded potential output more rapidly than the Fed had anticipated.
Now the president and Congress are considering some big policy changes aimed at boosting growth, such as tax cuts, infrastructure spending and deregulation. Economists disagree, to put it mildly, on what the consequences might be. In this challenging economic and political environment, attempting to estimate and target a long-run level of economic activity is an even more fraught endeavor.
The Fed would be better off using its policy tools to get inflation back up to target, rather than slow growth. And this argues against further tightening in 2017.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Footnote 20 of then Vice-Chair Janet Yellen’s 2012 discussion of “optimal control” is explicit about this aspect of what the Fed sees as desirable policy outcomes.
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