I recently attended a Hoover Institution monetary policy conference entitled, “How to get back on track.” But exactly what does it mean to get “back on track”?
That question got me thinking about why I struggle so much when people ask me whether I agree with current Fed monetary policy. I find the question difficult to answer because there are two distinct senses in which monetary policy can be off track:
1. The current stance of policy can be too easy or too tight, i.e., the fed funds target might be too low or too high relative to the natural rate.
2. The Fed might have the wrong policy regime. They might be doing growth rate targeting whereas they ought to be doing level targeting. That makes policy errors more likely.
I find that the average person sees the first question as being more important, whereas for me being “on track” is mostly about the second question. Thus some of my readers might assume that right now I, in some sense, “agree with Fed policy,” even though I actually disagree with the policy. Yes, I don’t see much evidence that the current stance of monetary policy is too easy or too tight, but if the economy ends up in the ditch next year, then I’ll probably blame the Fed. Would that be unfair Monday morning quarterbacking? I’ll use another sports analogy to try to illustrate my point.
Suppose a technical foul were called on the Lakers, and coach Steve Kerr of the Warriors chose Kevin Looney to shoot the technical free throw. I would severely criticize this decision, as Looney only shoots 60% whereas he could have used Steph Curry (who shoots 90% on free throws).
Now suppose someone asks me to predict the path of Looney’s free throw. I’ll say that I forecast it to go right through the basket. Yes, he’s fairly inaccurate, but I have no idea whether he’ll miss left or right or short or long. Think of a probability distribution with “fat tails,” where the center of the distribution is right on the basket. He’s not very accurate, but I am not aware of any systematic bias.
Even though I predict Looney’s shot will go toward the basket, I’d still criticize coach Kerr’s decision to use Looney if the shot missed. Similarly, while the current stance of monetary policy seems OK, the Fed’s “let bygones be bygones” policy regime produces a much less stable monetary policy than would a level targeting approach.
People will often point out to me that the financial markets did not predict a big inflation problem in mid-2021. In that case, is it fair to criticize the Fed for what happened later? Isn’t that just Monday morning quarterbacking? I’d say criticism is fair, because they should have had a regime in place where they promised to get back to the NGDP trend line after an overshoot. That promise would have made the initial overshoot much smaller.
Just as I would predict Kevin Looney’s shot to go toward the basket despite his poor skill at shooting, I will usually (not always) predict the future path of NGDP to be roughly where the Fed wants it to be. And I suspect that the markets have the same view. We don’t have an NGDP futures market, but the markets we do have seem to be implicitly predicting a slowdown in NGDP growth, but no severe recession. Thus interest rates are expected to fall later this year, but remain above 4%. A fall in interest rates would only occur if NGDP growth slows, and yet if there were a severe recession, then interest rates would fall to well below 4%. So far, so good.
At the conference, St. Louis Fed President James Bullard suggested that a soft landing is still very much in play. He pointed out that unlike in the early 1980s, inflation expectations are close to 2%. It’s much easier to bring down inflation if the higher rates have not yet become embedded in the public’s expectations. The Fed still has more credibility than in the early 1980s.
I mostly agree with Bullard, but I am a tad less optimistic due to my worry about the policy regime. Yes, markets seem to be forecasting a fairly good outcome. But that’s just the midpoint of the distribution—there’s still a worryingly wide range of possible outcomes.
We need to switch from a Kevin Looney Fed to a Steph Curry Fed. We need to shift from flexible inflation targeting to NGDP level targeting, so that when NGDP begins to drift off course there would be an immediate move in market interest rates that will nudge the Fed in the right direction.
P.S. It is the 30th anniversary of the Taylor Rule, and it was nice to see the conference honor John Taylor for his role in making monetary policy more precise during the late 1900s. Recessions became less frequent after 1982, which is about the time the Fed began using a more Taylor Rule-type approach to policy. I see level targeting as the next step.
P.P.S. Don’t take this post as a criticism of Looney, who is an excellent rebounder.
P.P.P.S. I’m tempted to say that level targeting would make monetary policy almost “Stephertless,” but I won’t.
READER COMMENTS
Spencer
May 14 2023 at 1:20pm
Gross Domestic Product accelerated relative to trend in early 2021:
Gross Domestic Product (GDP) | FRED | St. Louis Fed (stlouisfed.org)
But the effective funds rate remained constrained:
Federal Funds Effective Rate (FEDFUNDS) | FRED | St. Louis Fed (stlouisfed.org)
Spencer
May 14 2023 at 1:22pm
I’ll try this post.
It is the means-of-payment money supply measured by the distributed lag effect of money flows. The rate-of-change in M*Vt had already hit historic levels by Sept. 2020.
2/1/2020
,,,,,
1558.7
,,,,,
0.087
3/1/2020
,,,,,
1824.1
,,,,,
0.205
4/1/2020
,,,,,
2047.6
,,,,,
0.360
5/1/2020
,,,,,
2128.9
,,,,,
0.452
6/1/2020
,,,,,
2220.4
,,,,,
0.519
7/1/2020
,,,,,
2265.1
,,,,,
0.530
8/1/2020
,,,,,
2279.1
,,,,,
0.544
9/1/2020
,,,,,
2392.4
,,,,,
0.643
10/1/2020
,,,,,
2432.5
,,,,,
0.641
11/1/2020
,,,,,
2757.2
,,,,,
0.912
12/1/2020
,,,,,
3359.4
,,,,,
1.184
1/1/2021
,,,,,
3371.9
,,,,,
1.271
2/1/2021
,,,,,
3533.8
,,,,,
1.427
3/1/2021
,,,,,
3770.5
,,,,,
1.572
4/1/2021
,,,,,
3846.3
,,,,,
1.562
5/1/2021
,,,,,
4016.6
,,,,,
1.712
6/1/2021
,,,,,
4256.0
,,,,,
1.796
7/1/2021
,,,,,
4375.4
,,,,,
1.836
8/1/2021
,,,,,
4437.2
,,,,,
1.914
steve
May 14 2023 at 1:26pm
Maybe I am dense but you always say that we should engage in NGDP level targeting without saying how that would translate into actual policy or at least I dont remember any. Also, if markets were unable to predict inflation how would they respond to level targeting?
Steve
Scott Sumner
May 15 2023 at 1:42am
My new online book provides a fairly detailed explanation of how I think policy should be implemented. Ideally, use NGDP futures guardrails. If that’s not politically feasible, then target the forecast using a mixture of market indicators and economic models.
Markets were not able to predict inflation because they didn’t know what the Fed was trying to do.
Thomas Hutcheson
May 15 2023 at 10:11am
What policy instrument do you think would be most effective in achieving NGDPLT targeting, if buying and selling in the GDP futures market itself were not possible? If NGDP were knocked off track (e.g. covid), how quickly and how would policy instruments be used to get back on track?
Scott Sumner
May 16 2023 at 1:45am
They could buy and sell Treasury bonds.
I’ve generally argued that the Fed should target NGDP a year or two ahead, so that’s how fast they should try to get back on track.
vince
May 15 2023 at 12:04pm
The Fed said inflation was transitory. Wouldn’t that tell the market the Fed wouldn’t tighten?
Scott Sumner
May 16 2023 at 1:42am
That did contribute to the problem.
vince
May 14 2023 at 2:37pm
You’ve convinced me that the first question is the wrong one. No one can say what the natural rate is, and relying on it allows the Fed too much discretion. Almost any kind of transparent rule-based policy would have to be an improvement.
Isn’t the problem the politics of it? Insiders benefit from Fed discretion, insiders have power, and they won’t give it up without kicking and screaming.
Scott Sumner
May 16 2023 at 1:46am
“Insiders benefit from Fed discretion”
I see no evidence for that claim.
vince
May 16 2023 at 1:45pm
They’re not going to advertise it. How about Kaplan and Rosengren in 2021? They were followed by Clarida in 2022.
Scott Sumner
May 17 2023 at 1:23am
But that has nothing to do with the reason why the Fed uses discretion.
vince
May 17 2023 at 4:39pm
The discretionary approach gives the Fed more power. Why would any organization not have a preference for what gives them more power?
THOMAS HUTCHESON
May 14 2023 at 11:02pm
I go with something like 1, assuming that the regime is FAIT in which the F and the A are chosen to maximize real income. Then the question should be, I think, is the current settings of policy instruments: IOR, QE, FF rates (others?) correct to return inflation to an expected 2% PCE along a real income maximizing path, ~ a path that does not cause a recession.I think one could answer question 2 by saying that some other regime — maybe FANGDPT or F20xxNGDPTLT — would be better than FIAT.
Michael Sandifer
May 15 2023 at 12:24am
I see little, if any reason to blame the Fed for the current high inflation rate, even if monetary policy was somewhat too loose last year. The inflation breakevens are getting pretty well-below 2% now, which, if taken seriously, means most of the current excess inflation is related to supply-side factors and perhaps some residual expressions of pent-up demand. And that is if one assumes that there aren’t lagged components in the most recent inflation numbers that are overstating the current rate.
Of course, your general point is correct, and would greatly simplify Fed policy. You’re also correct that markets aren’t expecting a recession yet, for the reason you cite, and if you look at the S&P 500 futures curve, it certainly isn’t consistent with expectations of a recession caused by tight monetary policy. Ditto for recent strong jobs numbers.
Thomas Hutcheson
May 15 2023 at 10:15am
I think that the TIPS numbers DO represent expectation of recession. The 5-year is less than the 10-year and both are below target.
Michael Sandifer
May 15 2023 at 3:51pm
Yes, the yield curve is very negative by historical standards, and a negative yield curve has often preceded recessions, but it’s not a perfect predictor. Also, NGDP growth has been very high coming out of the pandemic, so the negative yield curve, while steep, isn’t steep enough to signal enough loss of growth to turn growth negative.
vince
May 15 2023 at 12:00pm
Could you explain how would S&P futures indicate a recession?
Michael Sandifer
May 15 2023 at 2:11pm
I wouldn’t expect the S&P 500 futures curve to be positive, if a recession was expected in the future. Of course, expectations of a strong enough recession would put us into recession now.
vince
May 15 2023 at 3:36pm
Thanks, but wouldn’t cost of carry and arbitrage control deviations from the spot price?
Michael Sandifer
May 15 2023 at 3:53pm
No, and in fact, it isn’t, to the degree that the curve is positive right now.
You can also look at options on S&P 500 index funds such as VOO or SPY.
Spencer
May 15 2023 at 8:08am
@Michael Sandifer
re: “The inflation breakevens are getting pretty well-below 2% now, which, if taken seriously, means most of the current excess inflation is related to supply-side factors”
Money flows are increasing, not decreasing. And interest rates don’t reflect inflation. And remember where inflation expectations were in 2021.
Greenspan never tightened and Bernanke never eased.
Powell hasn’t tightened. There are in excess of 2 trillion dollars in O/N RRPs.
Michael Sandifer
May 15 2023 at 2:12pm
Spencer,
Money was tight under Greenspan in circa 199o and 2000-2001, which helped cause those recessions.
Spencer
May 16 2023 at 8:07am
Yes, in the 1990-1991 recession, bank debits went negative for the first time since the GD.
And at the height of the Doc.com stock market bubble, Federal Reserve Chairman Alan Greenspan initiated a “tight” monetary policy (for 31 out of 34 months).
Greenspan then wildly reversed his “tight” money policy (at that point Greenspan was well behind the employment curve), and reverted to a very “easy” monetary policy — for 20 consecutive months (i.e., despite 14 raises in the FFR (June 30, 2004 until January 31, 2006), – every single rate hike was “behind the inflationary curve”, behind RoC’s in long-term money flows). I.e., Greenspan NEVER tightened monetary policy.
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