The Fed needs a new "theory"
By Scott Sumner
Caroline Baum directed me to a WSJ article on the Fed. It begins as follows:
The Federal Reserve’s interest-rate increases aren’t having the desired effect of cooling off Wall Street’s hot streak.
That’s already got me worried, as “Wall Street” is not a part of the Fed’s mandate.
In theory, financial conditions should serve as the conduit between the Fed’s monetary policy and the real economy. When the Fed lifts short-term rates, long-term rates should rise also and financial conditions should tighten.
Actually, “theory” predicts just the opposite. Textbook monetary theory suggests that the Fed directly impacts short-term rates, and affects long-term rates by influencing the expected rate of NGDP growth. If the Fed raises interest rates to tighten monetary policy that should reduce expected NGDP growth, which may well reduce longer-term interest rates.
The fact that the central bank and Wall Street are moving in opposite directions suggests limits to the Fed’s influence over the economy. If it persists, it could also prompt the Fed to shift its strategy. If your dance partner doesn’t follow, you might hold that person tighter.
Actually, it suggests just the opposite—that the Fed has a powerful influence on the economy. It is impacting expected NGDP growth.
“If we decide that we need to tighten financial conditions and we raise short-term interest rates and that doesn’t accomplish our objective, then we’re going to have to tighten short-term interest rates by more,” New York Fed President William Dudley told The Wall Street Journal last year.
That is precisely the policy that was followed in 1928-29. The Fed raised rates, and when Wall Street kept rising they raised rates even more.
It is still too early to say whether officials will raise rates more aggressively than planned. Still, Harvard University economist Jeremy Stein, a former Fed governor, said because financial conditions are so loose after three rate increases, the Fed is less likely to back away from its plan to keep raising rates, even in the face of low inflation.
This is why it’s so important to have the right “theory”. If the Fed tightens policy, then sees long term rates fall and wrongly assumes it has eased, then it will tighten even further. That may not end well.
Fortunately, the current stance of monetary policy is roughly appropriate. Unemployment is 4.3% and the consensus private sector forecast of inflation is about 2%. If anything policy may be a bit too tight, as TIPS spreads show sub-2% inflation expectations in the bond market. But overall, monetary policy is not currently causing major disruptions to the economy. Unfortunately, until the Fed gets the right model, it’s hard to have confidence that they will react any better to the next crisis than they did to the turmoil of late 1929, or 2008.
PS. I am not a Neo-Fisherian, but I wish there was at least one Neo-Fisherian on the FOMC, to clarify the relationship between monetary policy and long-term interest rates. Perhaps James Bullard can fill that role.
PPS. Nick Rowe uses the analogy of balancing a stick in one hand. If you want the top to move left, you move your hand to the right. If you want higher long-term rates, you cut short term-rates.