Don't try to normalize interest rates
By Scott Sumner
The Fed needs to keep raising short-term interest rates to diminish risks to the economy and markets of “excessive accommodation,” Mr. Kaplan told the Journal on Monday. However, fragile and interconnected financial markets, slow global growth, and the perils of driving the economy back into recession all mean the Fed can’t move aggressively, he said.
“We want to try to normalize [interest rates] as fast as we can,” Mr. Kaplan said in a Dallas office stuffed with memorabilia from his home state of Kansas and with management “how to” books he wrote at Harvard. “But we have to be patient and gradual.
I was most struck by the term “normalize”. I was not aware that there was any normal level of interest rates. I’ve observed rates ranging from 0% to roughly 20%, and in some countries rates have recently gone negative.
Is this a harmless concept? I don’t think so. If the Fed is trying to normalize interest rates as fast as they can, then interest rates have become a goal of Fed policy, in addition to employment and inflation. And that means they are willing to trade off worse outcomes of employment and inflation in order to get better outcomes for interest rates.
I also see an even great danger. In the past, the Fed’s biggest errors occurred in the 1930s, in 1966-81, and in 2008. (And yes, Bernanke has now admitted the Fed should have cut rates faster in 2008.) In all three cases, interest rates were already “abnormal” and the appropriate policy was to make them even more abnormal. Now think about Kaplan’s view that the Fed should want to normalize rates as fast as possible. People holding that view in the 1930s, the 1970s, or 2008 would have been likely to make the exact policy errors that led to our greatest monetary disasters.
Maybe the Fed should try to control the variables that actually lead to economic instability, and let the market determine what level of interest rates is “normal.”
Notice that I have not said that the Fed should provide a collective forecast for its short-term interest rate target. Policymakers’ forecasts are inevitably seen as something akin to commitments. The Fed should be committed to delivering particular inflation and employment outcomes, not to a specific path for interest rates.