If things are going well
There are an increasing number of pundits suggesting that we may be on track for a soft landing. I don’t have strong views either way, but let’s assume that is the case; the US is increasingly likely to achieve a soft landing. What then? What should the Fed do next?
One answer is, “Keep doing what it’s doing, as that seems to be working.” But it’s not clear what it means to maintain a steady monetary policy, as the economics profession has never provided a satisfactory definition of “monetary policy.” Indeed, I wrote an entire book on this subject, which (I hope) will come out soon.
Karl Smith likes what he sees, and suggests that the economy is doing so well (in terms of achieving a soft landing) that the Fed should hold off on further rate increases. This view makes sense if we assume that stable interest rates represent a stable monetary policy. (Note: Smith also looks at indicators such as money supply growth, so his views are more nuanced than I’ve indicated here. Read his Bloomberg piece.)
Someone else might look at the same evidence and agree that policy should stay the course. But for them, staying the course might be implementing the interest rate increases that the Fed has been predicting in recent meetings. After all, those predicted rate increases influence long-term interest rates, and the economy seems to be doing well at the current level of long-term rates. So should we stay the course by carrying out the Fed’s predicted rate increases?
A third pundit might argue that the Fed “dot plot” is not fully credible. The market expects a slightly lower path for interest rates than the path predicted by the Fed. And it’s the market expectation of the future path of rates that the economy is reacting to. So perhaps the Fed should not keep rates where they are, nor should they raise them at the pace they have predicted. Instead, if the economy is doing well then perhaps the Fed should raise rates at the pace that the market is predicting.
I don’t much like any of these views, as they all rely on interest rate targeting. And I don’t believe the Fed should be targeting interest rates—let the financial markets set rates. But if the Fed insists on setting rates, and if the economy is indeed on track for a soft landing, then the least bad policy would be to have rates follow a path equivalent to the current market prediction.
Once again, I am not advocating that policy; I’m saying that policy would be appropriate if we are now on track for a soft landing. My own view is that the risks are still slightly to the upside, toward overheating.
P.S. In a new article I wrote for the National Review, I point out that low and stable NGDP growth is a necessary and sufficient condition for the Fed to achieve its policy goals:
The Fed does not currently target nominal spending. But as a practical matter, the Fed cannot achieve its goal of low inflation and high employment without stable nominal-spending growth. Whenever spending growth is far below 4 percent, unemployment will rise sharply. Whenever it is far above 4 percent, inflation will rise. Because spending growth is the sum of inflation and real GDP growth, it is the best single indicator of the Fed’s performance.
A policy target of 4 percent spending growth is much more credible and transparent than a vague policy aimed at 2 percent inflation and high employment. How should high employment be defined? The Fed doesn’t tell us. How does it balance the goals of avoiding high inflation and encouraging high employment? The Fed doesn’t tell us. What does it do if it misses a policy goal? Again, the Fed doesn’t tell us.
Read the whole thing.
Jan 25 2023 at 3:54pm
re: “let the financial markets set rates”
That’s exactly how you get high real rates of interest for saver-holders.
Jan 25 2023 at 4:07pm
re: “reliance on the discretion of policy-makers has often resulted in significant mistakes”
The mistakes involved ignoring legal reserves – monetarism’s true policy instrument.
Thomas Lee Hutcheson
Jan 25 2023 at 4:51pm
It would be better to avoid the word “policy.” I hope the Fed’s “policy” is maximum endowment with stable prices, which it says means a flexible average inflation target of 2% of the PCE. The question is what settings should it chose for its policy instruments, FF rate, IOR, changes in QE balances, etc. and what should it be saying about future settings.I too have to much confidence in predicting a “soft landing.” Since the market is expecting it to undershoot it’s target, it should surprise the market with settings of its instruments. mainly FF rates, probably, that lower than what the market expects, whatever that is. FWIW I think this means no increase in the next setting and not announcement of future settings. Reiterating its policy would not be out of order.
Jan 25 2023 at 4:54pm
The NR piece is good. You mention inflation swaps at one point. I had sent an email to your Bentley account about the inflation fixings market, but hadn’t heard anything back.
In the article above you say: “I don’t much like any of these views, as they all rely on interest rate targeting. And I don’t believe the Fed should be targeting interest rates—let the financial markets set rates. But if the Fed insists on setting rates, and if the economy is indeed on track for a soft landing, then the least bad policy would be to have rates follow a path equivalent to the current market prediction.”
I get that you favor futures contracts, but interest rate targeting is just bout the instrument that the Fed is using to achieve its policy goals. You could have a nominal GDP level target with interest rate targeting. It’s open question how much additional improvement there is in changing the instrument from interest rates to the futures approach, assuming the goal (nominal GDP level) remains the same. I think you make a good case, but they are separate.
From this perspective, following market yields isn’t necessarily good or bad. Market yields depend on expectations of Fed policy and the economy. If the Fed has some policy rule that is different from nominal GDP level targeting, then the market expectations of policy will be based on that.
Jan 25 2023 at 8:14pm
To be clear, following market forecasts only makes sense when you believe that policy is on track in terms of the future expected path of aggregate demand.
So in the absence of NGDP futures, there’s no substitute for estimating future growth in demand.
And yes, if the Fed is targeting inflation, then that’s the criterion they should use in evaluating market forecasts of interest rates.
Jan 26 2023 at 3:24pm
Yes, the long-run target is different from the short-run instrument. The Fed is wrong about both.
The Fed is wrong about the long-run target, because it has a mandate for both inflation and unemployment, but no explicit trade off between the two. Moreover, it uses growth rate targeting, when it should use level targeting (to make up for past errors).
The Fed is wrong about the short-run instrument, because its actual concrete action is changes to the money supply (monetary base), and describing and communicating these concrete changes by means of changes to the interest rate target confuse whether the changes are achieved via monetary contraction or monetary stimulus. The same free market interest rate can be achieved by completely opposite economic actions.
Worse, the interest rate target suffers from the Zero Lower Bound problem, even though actual monetary policy does not, so this is a completely self-imposed artificial limit. Sumner once described it like this: “Our current monetary regime is roughly like a car with a steering wheel that works fine — except when driving on twisting mountain roads with no guard rail.”
Jan 25 2023 at 7:56pm
Can the Fed significantly change NGDP without disrupting markets? Its control of the monetary base is not necessarily control of NGDP. QE, for example, may inflate asset prices more than NGDP.
Jan 25 2023 at 8:17pm
Markets are disrupted when the Fed causes NGDP instability. The goal should be slow and steady NGDP growth, which is the best way to ensure market stability.
QE is not a good indicator of monetary policy.
Jan 25 2023 at 8:41pm
It also seems that NGDP goals should be more of the responsibility of economic policy of the government rather than the central bank.
The Federal Reserve Act says the Fed’s objective is to maintain long run growth of monetary and credit aggregates commensurate with the economy’s long run potential to increase production.
With that objective, shouldn’t the Fed take a more passive approach and simply ensure that enough money and credit is available for real economic activity–with real economic activity being more dependent on non-monetary economic policies?
Jan 25 2023 at 8:01pm
From the National Review article:
It might be impractical due to intertia, but it seems like a goal of zero inflation would provide better price stability. Just as deflation might artificially postpone consumption, inflation artificially accelerates it.
Jan 25 2023 at 8:16pm
I’ve discussed that issue extensively in other posts. Yes, zero inflation is price stability, but positive inflation might be better able to achieve the Fed’s dual mandate.
Grand Rapids Mike
Jan 26 2023 at 9:37pm
One way to reduce inflation is change how it is measured.
Jan 27 2023 at 12:50pm
They’ve already done that.
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