I’ve recently noticed a lot of pessimism about what monetary policy can accomplish. For instance, if I discuss a higher inflation target, people will say, “what makes you think the Fed could hit a higher inflation target? After all, they have trouble hitting their current inflation target.”

This is incorrect for lots of reasons, and I think some of the reasons are interesting enough to explore. But first, one obvious but boring flaw with the pessimist’s argument:

1. The Fed targets their internal forecast of expected future inflation, and they’ve been successful in hitting that target in recent years. Now it’s true that actual inflation has often fallen a bit short of their expectations, but that has no bearing on whether they could boost expected inflation. If bias in the Fed model results in their expected inflation estimate being 0.5% above the market expectation (say TIPS spreads) that gap would be equally likely to occur at a 4% inflation target as at a 2% target. Thus this sort of policy change would raise market inflation expectations from 1.5% to 3.5%.

The Fed is not cutting rates right now because they fear that it would lead to above 2% inflation going forward, not because they are out of ammo.

2. But I also think there is a more interesting mistake being made. People look at the path of interest rates, and wrongly conclude that they are looking at the path of monetary policy. They see that low rates have failed to boost inflation, and so conclude that monetary policy is not very effective.

But even in the (new) Keynesian model, interest rates do not represent the path of monetary policy. Rather what matters is the gap between the actual target rate and the Wicksellian equilibrium rate. In standard fiat money models, pegging the policy rate just 0.25% above or below the natural rate, and holding it there regardless of the condition of the economy, will quickly lead to hyperinflation or hyperdeflation.

Consider this simple example. The Fed cuts its target rate to 0.25% below equilibrium, and holds it there even if inflation expectations rise. Since the rate is now 0.25% below equilibrium, inflation expectations rise by a small amount, say 0.1%. But now rates are 0.35% below equilibrium in real terms, so policy is easier and thus inflation rises by even more, say 0.15%. But now real interest rates are 0.5% below equilibrium, so policy is even more expansionary and inflation expectations rise by even more, say 0.30%. But now real interest rates are 0.8% below equilibrium, and policy is becoming extremely expansionary. Rinse and repeat, and in a few years you have hyperinflation. If rates start out too high, you quickly end up with hyperdeflation

As far as I know, this has never happened, at least all the way to hyperinflation. Although to a lesser extent its what happened during the Great Inflation. And there’s a reason we don’t see this sort of extreme snowball effect—central banks aren’t that dumb. (Actual hyperinflations occur for other reasons—chiefly monetizing the debt.)

In late 2015, the Fed raised its target rate by 0.25%, and announced that they expected to do 4 more rate increases in 2016. They probably slightly misjudged the future path of the Wicksellian equilibrium rates. In early 2016, the markets started warning the Fed that if they persevered with their plan to raise rates 4 times in 2016, the economy would enter a death spiral. Of course markets knew the Fed would not make that big a mistake, but there were seriously concerned about a smaller mistake. So you saw a combination of the market predicting 2 rate increases, and also predicting inflation would come in below the Fed’s 2% target. Here’s what markets were saying, translated into plain English:

1. We think that 4 rate increases would create a disastrous slump.

2. We think that the Fed will actually only do 2 rate increases, and even that will be too much.

3. We think fewer than 2 rates increases would be consistent with an expected inflation rate equal to the Fed’s 2% target.

In other words, the markets expected the Fed to mostly “see the light”, but not entirely.

The monetary policy pessimists tend to be unaware of all of this behind the scenes stuff going on with market expectations and Fed policy. There’s a complex and delicate game being played, where the Fed tries to read the markets, as the markets try to read the Fed. If the Fed reads the markets pretty well, the interest rate will always be close to the Wicksellian equilibrium rate. In that case it won’t look like interest rate changes “do anything”, as they will occur in the fashion required to keep the macroeconomy stable. And if the Fed consistently keeps rates a tad too high, but otherwise closely shadows the equilibrium rate, it will seem like the Fed is “doing something” but is consistently unable to hit it’s inflation target.

In fact, if the Fed did something wild and crazy, we’d see a dramatic market response, but we almost never see the Fed take an extreme position, perhaps with the exception of the Volcker disinflation, or the tight money policy of late 1929. The closest example in recent history occurred in October 2008, when the target rate (1.5% to 2.0%) rose far above the Wicksellian equilibrium rate. But that did not occur as a result of the Fed raising the target interest rate, but rather not cutting it as required to keep market inflation expectations close to 2%.

To conclude, there is no reason to be pessimistic about the efficacy of monetary policy, unless it is constrained by legal restrictions (say an exchange rate peg, or limits on what sort of assets the central bank can purchase.)

And remember, even if restricted to conventional interest rate policy, the Fed has 5 quarter point rate cuts in its quiver, before reaching Swiss IOR levels.