The Fed is not doing its job
By Scott Sumner
Here’s a recent WSJ report on the economy:
Many Federal Reserve officials entered 2015 thinking they likely would start raising short-term interest rates by midyear. That idea got put on ice after a winter economic slowdown, partly attributed to the dollar’s rapid rise in previous months.
While the dollar’s value is down a bit from its March peak, the Fed’s own models show the greenback’s drag on the economy is likely to grow in coming months.
This and other factors could prompt some Fed officials to lower their latest growth forecasts, to be released at the next Fed policy meeting June 16-17–and to wait even longer to move on rates.
If we make the highly plausible assumption that the Fed’s two-year forward NGDP forecast is also declining, then we can infer that the Fed is not doing its job. Its job is not to adjust its forecasts up or down, but rather adjust its policy so that its longer-term forecast never needs to be revised.
The article also suggests that Janet Yellen is confused about the current stance of monetary policy:
At their March meeting, Fed officials lowered their expectations for U.S. growth to a range of 2.3% to 2.7% this year and next. In December they had estimated a pace as high as 3% for both years.
Fed Chairwoman Janet Yellen attributed some of the March downgrade to the dollar’s strength. “Export growth has weakened. Probably the strong dollar is one reason for that,” Ms. Yellen said at her March news conference.
There are all sorts of problems here, starting with reasoning from a price change. Price changes are not good or bad for the economy. They have no effect. Instead they are the effect of other deeper forces. If the dollar rose because of monetary stimulus at the ECB and BOJ, that’s a bullish indicator for America. If it rose due to tight money at the Fed, that’s bearish.
Let’s say Yellen is right that the recent increase in the dollar is a bearish sign for the US economy. There’s still a problem with her statement. She seems to suggest that the strong dollar is some sort of exogenous shock that unfortunately hit the US, causing the Fed to miss its targets. But if it is in fact contractionary, then the “shock” has been caused by excessively tight monetary policy. A strong dollar in the foreign exchange markets doesn’t cause NGDP growth to fall, tight money does.
Inevitably some commenters get confused about what I mean by “tight money”. I use the Bernanke (2003) definition, which relies on indicators like NGDP growth. But even if you prefer the more popular New Keynesian (NK) definition, money is clearly getting tighter. The NKs look at the future path of interest rates. In their model an expected increase in the future target interest rate has, ceteris paribus, a contractionary impact today. Indeed the NK model predicts that promises of future interest rate increases will cause the dollar to appreciate, which the Fed believes slows growth and reduces inflation. So even if you don’t like Bernanke’s unconventional NGDP-based criterion for determining the stance of policy, money has clearly been getting tighter.
The Fed needs to stop looking for mysterious outside forces impacting spending, and begin to realize that monetary policy alone determines the path of nominal spending in the economy. If it doesn’t like that path, change the policy. By merely wringing its hands about a slowdown in growth, it is failing to do its job.
PS. I also recommend this article by Caroline Baum, which makes some similar points.
PPS. Here’s an even more discouraging statement:
But perhaps Ben should consult Stanley Fischer, the Fed’s current vice chairman, who recently said on CNBC that “we are going to be changing monetary policy from the most extremely expansionary we’ve been able to do in all of history to an extremely expansionary monetary policy.”
Stanley Fischer is arguably the most distinguished monetary economist in the world. But in this case he has things exactly backward. The Fed’s monetary policy since 2008 has been the most contractionary since the early 1930s. Fischer is 180 degrees off course.