Cutting rates would not be reversing course
By Scott Sumner
Watching the fed funds futures markets, it’s easy to see why the US has never had a successful soft landing. Even now, when inflation is not a problem, it’s not easy for the Fed to steer the nominal economy, at least using its current operating system. Interest rate futures have been falling rapidly, and the markets are now forecasting two 1/4% rate cuts by late 2020. Now imagine (as is usually the case late in a boom) that inflation were becoming a problem. The Fed would have to be extremely nimble. In most cases, the Fed creates recessions by tightening late in the cycle, when inflation is rising above target at the same time that NGDP expectations are falling. There’s often an inverted yield curve.
One aspect of this problem has not received enough attention—the perception that reversing course on a path of rate increases is in some way an admission of error. And no one likes to admit they were wrong.
But that perception is false, as interest rates are not monetary policy. If anything, NGDP growth (or inflation and employment if you prefer) are the correct indicators of monetary policy. Pushing inflation up to 3% and then back down to 2% is the sort of thing that should be regarded as an admission of error.
Here’s an analogy that might be helpful. If you watch a bus driver turn right, go to the end of a dead end street, and then turn around and go in the other direction, it’s pretty clear he made a mistake. But if you see a bus driver turn the steering wheel left, then right, then left, all the while staying on the correct highway, then no mistake has been made. He’s just steering the bus. What matters is the road you are traversing, not the nudges of the steering wheel.
In this analogy, fed funds targets are like the steering wheel, and NGDP growth is like the road.
Unfortunately, the perception that reversing course on rates constitutes an admission of error actually causes policy to be less effective, less nimble, more inertial. That will lead to worse outcomes than if the policy world (officials, reporters, pundits, economists, bankers, Trump, etc.) did not have that perception.
Last year I published a piece in The Hill, which offered a solution to this problem. The Fed funds target would be changed daily, and in increments as small as a single basis point. This would cause it to follow something closer to a random walk, which is how it would look if NGDP futures markets were directing policy. The rate would be set at the median vote of FOMC members, using all 100 basis points, which would be emailed in to Jay Powell each morning. Under this sort of regime, everyone would become used to the rate moving up and down frequently, often in small increments. There would be no embarrassment if the Fed changed course, as they would do so frequently.
Not surprisingly, no one pays any attention to my suggestions. I’m not the sort of person that would get invited to the Fed’s rethink of monetary policy this June, because I don’t publish papers with lots of equations. Still, I’ll keep beating the drum for this idea in the hope that someone more influential will pick it up. And that’s because right now is exactly the sort of situation where my proposal would be quite useful. If the fed funds futures are correct and rate cuts are on the way, the inertia in Fed policy may cause them to occur too slowly. By the time the cuts are made, the natural interest rate might fall so far that much deeper cuts are needed than otherwise.
Of course I can’t be sure that any rate cuts will be needed. Markets move around a lot, and it’s possible that growth will be stronger than markets currently predict. But if the markets are correct, then there’s a good chance that the Fed will respond more slowly than would be optimal.
Again, a Fed reversal would not be an admission of error. What really matters is the goals of Fed policy, such as 2% inflation and high employment. And on that score they’ve recently been doing pretty well. If nudging interest rates up and then nudging them back down is what’s needed to keep inflation near 2% and unemployment near 4%, then in no sense would those ups and downs have been a “mistake”. After all, 2018 was a very strong year.
The following story caught my eye (and notice how my plan would make it easier for Bullard to adjust policy “a little bit”):
Two of the Federal Reserve’s most dovish officials on Friday both shied away from calling for the central bank to cut interest rates. St. Louis Fed President James Bullard, in an interview with the Wall Street Journal on Friday, said the central bank may have tightened “a little bit too far” but didn’t call for reversing course. Earlier, Minneapolis Fed President Neel Kashkari said only that he thinks the Fed is close to a neutral policy stance and he hoped the central bank hadn’t pushed its benchmark Fed funds rate up to a level that was causing the economy to contract.
Those are certainly defensible statements. But this isn’t (from the Fed’s November 1937 transcript):
We all know how it developed. There was a feeling last spring that things were going pretty fast… If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System [Fed] was the cause of the downturn. It makes a bad record and confused thinking. … I would rather not muddy the record with action that might be misinterpreted.
That horrific statement (referring the the previous doubling of reserve requirements, and a reluctance to reverse it) should be carved into the marble walls of the Fed building, so that Fed officials have to read it every single day, as they walk into work.
PS. Bonus points for the person that can answer the following puzzle. I said the markets currently predict two 1/4 point rate cuts in the next 20 months. I also believe the Fed should follow the markets, and eventually does follow the markets. Explain why if the Fed were to adopt my proposal, starting today, they probably would not have to cut rates twice, perhaps not at all!
If I’d asked that sort of question at Bentley, my students would have had me tarred and feathered. 🙂