Some Ways to Put More Oomph in the Fed's Punch
When it comes to monetary policy, there will always be disagreement. Interest rates are a sensitive topic, since they affect everything from bond returns to the price of a mortgage. And monetary policy is confusing, since despite decades of hard work, no one really has a reliable general model of how policy affects the macroeconomy. Add politics to confusion, and the result is a roiling debate that never ends.
To help cut through this chaos, many economists have sought a rule to guide the Federal Reserve in its policy decisions. Rules provide an easy, automatic map from economic observations to policy variables like interest rates. More flexible than a rule is a monetary policy target. A target doesn’t tell the Fed exactly what to do, but it gives it a goal. For example, many central banks now use an inflation target -- for the Fed, the official target is 2 percent inflation. The Fed is free to do whatever it thinks it needs to do to hit that target.
But since the financial crisis of 2008, a growing chorus of voices has advocated for a change in the Fed’s policy target. It’s taken the economy almost a decade to recover from that episode, and many would argue that the recovery isn’t complete even now. Prime-age employment levels aren’t even back to where they were before the crisis hit:
Meanwhile, core inflation (excluding volatile food and energy prices) has remained low, often below the Fed's official target:
That has convinced many that the central bank should have been doing more to return the economy to robust levels of growth. For example, Scott Sumner of the Mercatus Center at George Mason University has consistently advocated an approach known as nominal gross domestic product targeting, or NGDP targeting, and my Bloomberg View colleague Ramesh Ponnuru has endorsed it as well. NGDP growth is just real economic growth multiplied by inflation, so when either of those things gets too low -- if there’s a recession, or deflation -- NGDP targeting says that the Fed should adopt a more inflationary, pro-growth policy.
NGDP has historically grown at an exponential rate in the U.S., but since the recession slow growth and slow inflation have caused it to lag below its trend line:
A similar approach, recently suggested by John Williams, president of the Federal Reserve Bank of San Francisco, is price level targeting. Instead of trying to keep NGDP on a steady long-term trend line, the central bank just tries to keep prices on track. If the economy has suffered years of unusually slow inflation, price level targeting would allow higher inflation in order to make up the lost ground. That would also imply a more inflationary monetary policy right now:
Economist Larry Summers has also made a similar suggestion.
A third idea is to make the inflation target itself flexible. If inflation consistently fails to reach its normal target, it may be a sign that people don’t believe the Fed is willing to let inflation exceed the 2 percent mark -- in other words, the market may believe that 2 percent represents a ceiling, not a target. To dispel those notions, it might help to temporarily raise the inflation target. A group of 22 economists recently signed an open letter to the Fed, advocating a temporarily higher target.
Though these approaches are different in theory, they’re all fundamentally similar reactions to current conditions. The Fed is now in the process of raising interest rates, despite the economy barely having emerged from a decade of stagnation. NGDP targeting, price level targeting and a higher inflation target are all gaining credence because of a general feeling that the Fed is hiking too soon.
That impulse is understandable. But before the Fed embraces one of these approaches, it needs to think carefully about how to carry it out in practice. Targets are well and good, but they don’t come with a user’s manual telling the Fed how to hit the target.
Usually, economists think that the way to boost growth and inflation is to keep interest rates lower for longer. But that doesn’t always seem to work in practice. Interest rates have been at or near zero for decades in Japan, and that country has consistently had very low inflation. A few macroeconomists even believe that keeping rates low for a long time has the opposite of the intended effect, and actually causes disinflation, or a decline in the inflation rate. As for the Fed's program of quantitative easing, it wasn’t clear whether repeated rounds of financial asset purchases had much of an effect in the U.S.
A third option is forward guidance -- the Fed can declare its intent to leave rates low for a long time in the future. But economists have also come to doubt the power of this tool. Also, it’s an open question as to how much people even believe the Fed’s promises. If the Fed said that it was willing to let inflation get to 4 percent, would businesses and consumers really take it at its word?
So while the Fed should consider these alternate approaches, there’s a decent chance that none of them will achieve the desired effect. Good monetary policy is easier said than done.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the author of this story:
Noah Smith at firstname.lastname@example.org
To contact the editor responsible for this story:
James Greiff at email@example.com