I’ve been obsessed with monetary policy for most of my life and at age 64 I rarely change my mind on this issue. But today I’ve changed my mind on the Fed’s so-called dual mandate, which is actually a triple mandate:
In 1977, Congress amended the Federal Reserve Act, directing the Board of Governors of the Federal Reserve System and the Federal Open Market Committee to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
Economists have tended to ignore the “moderate long-term interest rates” part of the mandate, for two reasons. First, it’s widely believed that the Fed does not have much impact on long-term interest rates, except by controlling the trend rate of inflation. Second, the Fed’s 2% inflation target already insures relatively moderate long-term interest rates, which suggests that the third mandate is redundant. Recall that the high interest rates of the late 1970s reflected high inflation expectations.
I used to buy into this view, but now I believe we should take the third mandate seriously. But what does “moderate” interest rates actually mean? And what do we mean by “mean”. As an analogy, did the legislators who banned discrimination based on gender back in the 1960s intend that this law would also apply to discrimination based on sexual orientation? And is that what matters, or should we think in terms of how they would view their intentions from the perspective of 2020—if they could be transported here in a time machine? The Supreme Court recently struggled with that issue.
I suspect that in 1977, legislators meant by “moderate” something like “not too high”. But the actual term “moderate” does not literally mean “not too high”, it means not at either extreme. We also know that once long-term interest rates hit unimaginably low levels of zero of even negative in places like Germany and Japan, many public officials became concerned that low rates were hurting savers. Thus it is not unreasonable to assume that “moderate” means avoiding both really low interest rates that would hurt savers and really high rates that would hurt borrowers. This interpretation meets the letter of the law as well as the likely intent of legislators once they understand that zero or negative rates on long-term bonds are possible, something they may not have even imagined in 1977.
In the recent case where the Supreme Court applied the 1964 Civil Rights Act to discrimination based on sexual orientation, I believe they were at least partly motivated by the fact that society increasingly opposes this sort of discrimination. That may not be legally sound reasoning, but I especially doubt whether the four “liberal” justices would have used this sort of creative interpretation if it had led to what they saw as a highly objectionable public policy outcome. Thus liberal justices use the vague “right to privacy” concept in abortion cases but not heroin possession cases.
If we return to monetary policy, then there are two very pragmatic reasons why we might choose to take the third mandate seriously. If one interprets “moderate long-term interest rates” as long-term T-bond yields in the historically normal range of 3% to 6%, then it can be seen as requiring that the Fed insure a NGDP growth rate that it high enough to keep long-term rates in that normal range, at least most of the time. And I don’t believe the Fed is currently doing that. Ten-year T-bonds yield barely 1/2%.
I see two advantages to maintaining a trend rate of NGDP growth that is fast enough to keep long-term rates moderate:
1. Less of a zero lower bound problem for monetary policy. While it is possible to do effective monetary stimulus at the zero lower bound, in practice monetary policy usually becomes too contractionary at the zero bound.
2. A smaller Fed balance sheet. At the zero bound the demand for base money rises rapidly. This leads to the Fed buying lots of assets to meet this demand, and this might have a distortionary effect on the economy. This is especially true if they continue their recent policy of going beyond the Treasury market in their asset purchases.
Thus in order to keep away from the zero lower bound and to maintain a small Fed balance sheet, it makes sense to take the third mandate seriously.
You might think that “low interest rate guys” like President Trump would oppose this policy change. But that’s reasoning from a price change. In this case, the higher nominal interest rates would be achieved through an expansionary monetary policy (a NeoFisherian approach) and hence would have more support from politicians than you might normally assume from the phrase “higher interest rate policy”. My proposal would not raise real long-term interest rates and would boost growth in the short run.
READER COMMENTS
Michael Sandifer
Aug 8 2020 at 5:14pm
This all seems plausible, except that your proposal would not raise real long-term interest rates, depending on how “long-term” is defined. There seems to be no SRAS curve near the ZLB. It’s been stretched way out.
Scott Sumner
Aug 8 2020 at 7:08pm
Yes, but the goal is to raise nominal rates, not real rates. Look at the two justifications I provide; they both refer to nominal rates.
Thomas Hutcheson
Aug 8 2020 at 5:58pm
I do not see the utility of taking the “moderate interest rates” objective seriously. 1) If the Fed is already not meting its full employment and inflation targets, how does emphasizing yet another objective help? 2) Unlike inflation and full employment, the nominal rate of interest does not have an independent effect on real income growth. Suppose we had a rip roaring investment boom (say as a result of attracting millions of new immigrants) and it required a 1o% nominal interest rate to keep inflation at 2% PCE? Would we really want the Fed to try to reduce that rate?
Don Geddis
Aug 9 2020 at 10:08pm
Inflation also “does not have an independent effect on real income growth”.
Thomas Hutcheson
Aug 10 2020 at 9:04am
The reason there is an optimal rate of inflation (maybe 2% PCE or not) is that higher inflation makes it more difficult to predict future relative prices, which is necessary for investment.
David Andolfatto
Aug 8 2020 at 9:33pm
That’s not a NeoFisherian approach, Scott.
NeoFisherism asserts that long run inflation can be raised by increasing the policy rate and keeping it there. What you are advocating is standard monetary policy — increase the pace of money creation to increase inflation, which then let’s CB raise rates.
Scott Sumner
Aug 8 2020 at 10:17pm
David, Fair point. I’m currently working on a paper on NeoFisherian policy. I agree that higher interest rates are not a monetary policy; they are an effect of monetary policy (or other factors). I just meant that if people insist on thinking of monetary policy in terms of interest rates (as most people foolishly do) then they should think of this move in NeoFisherian terms.
I believe both the Keynesians and the NeoFisherians are wrong. Lower rates aren’t easier money and they aren’t tighter money. They aren’t monetary policy at all.
Matthias Goergens
Aug 9 2020 at 3:15am
Stable nominal GDP doesn’t imply a high demand for base money, as long as you allow commercial banks to issue bank notes in their own name.
See the well-known example of Scottish free banking, that used very little base money (ie gold). A similar system would work with small amounts of Fed balances as base money.
Paul A Sand
Aug 9 2020 at 7:30am
Obligatory Monty Python.
Scott Sumner
Aug 10 2020 at 5:53pm
Fond memories.
Daniel Culley
Aug 9 2020 at 8:12am
I know it’s not the point of your post, but it continues to drive me nuts that people keep saying that the original legislators wouldn’t have thought the Civil Rights Act of 1964 would have “covered” discrimination based on sexual orientation or identity. I doubt many of them would actually have been surprised that it covered e.g., not being “manly” enough.
They would, however, have told you that as an employer you obviously don’t have to hire someone who is depraved or has a mental disorder. (And mind you this is also 26 years before the ADA, so no reasonable accommodation required for mental disorders.) So it would have been obvious to them that you could fire someone for being gay.
We obviously today have a quite different understanding of what, for example, being homosexual means in terms of one’s morality or mental fitness. But that is exactly the type of fact-based case application that courts normally do and leads to different results over time all the time. For example, carry 150 lbs might be a legitimate job qualification for a firefighter today, notwithstanding its disparate impact. But thirty years from now we might all use robots to do the heavy lifting on firefighting, and it wouldn’t be a reasonable qualification anymore.
Of course, a similar line of reasoning can apply to your third mandate: when your understanding of economic theory implies the Fed can control long-term rates, it may mean the Fed needs to do one thing; if you learn it cannot, then it may imply a different course of action.
Vanessa
Aug 9 2020 at 9:28am
I had assumed the thing you changed your mind on when I clicked the article was the existence of the Fed at all. It promotes hyperinflation and the devaluation of our currency, not sound money. The government and the Fed hold a monopoly (something that would be bad in any other industry) on money production, legal tender, and the price of money (interest rates).
The money industry needs to be decentralized and controlled by the competitive forces of the free market. The idea that inflation is normal and natural is inane, we should see deflation and the reduction of prices in an ever innovating economy and it’s too bad our overlords won’t even allows us the freedom of our money.
Doug Radford
Aug 9 2020 at 1:20pm
Vanessa, 100% agreement about deflation. How has the idea of deflation become demonized? It is because of excessive corporate debt. The business model doesn’t let the price of homes go down, or anything else for that matter, because of the ensuing defaults that would occur.
Don Geddis
Aug 9 2020 at 10:15pm
The US Federal Reserve has been around for more than a century. Not a single time has there been an episode of hyperinflation. If it “promotes hyperinflation”, it certainly doesn’t do it very well.
Interest rates are the price of credit, not the price of money.
The Fed has no monopoly on interest rates. Interest rates are floating free market prices. The Fed only targets interest rates; it doesn’t set them. (There’s a huge difference. The Fed has the power to target any nominal price. That doesn’t at all mean that it has any monopoly in that industry.)
Scott Sumner
Aug 10 2020 at 5:56pm
People are already free to use alternative monies such as gold and Bitcoin.
Philippe Bélanger
Aug 9 2020 at 2:25pm
What if secular forces push the real interest rate deeply into negative territory? The Fed would then have to target a high rate of inflation in order to keep nominal rates stable. If growth keeps slowing down and interest rates keep falling, this policy could lead to a mild form of stagflation.
Scott Sumner
Aug 10 2020 at 5:57pm
Yes, but the main cost of high inflation is high nominal interest rates. So if the inflation rate is raised to offset a fall in the real interest rate, that sort of inflation would not be very costly.
Spencer Hall
Aug 10 2020 at 10:02am
re: “then it can be seen as requiring that the Fed insure a NGDP growth rate that it high enough to keep long-term rates in that normal range”
Et tu, Brute? First, economists don’t know a debit from a credit, money from mud pie. N-gDp level targeting is money illusion. As nominal interest rates rise, more savings become impounded and ensconced in the payment’s system (as Regulation Q ceilings were abolished). Thus, money velocity falls, and AD falls with it. So the FED, to hit its NGDP growth rate, eases more and more.
Banks are not financial intermediaries. Banks pay for their earning assets, from the standpoint of the forest, with new money – not existing deposits. All 15 trillion dollars of bank-held savings are frozen. The only way to activate monetary savings, is for their owners to spend/invest directly or indirectly via for example, nonbank financial intermediaries.
Indeed, real interest rates will fall under such a policy. But it is real rates that are the most important economic drivers of CAPEX. An increase in money products decreases the real rate of interest and has a negative economic multiplier. An increase in savings products increases the real rate of interest and has a positive economic multiplier.
Spencer Hall
Aug 10 2020 at 10:08am
The solution to Alvin Hansen’s 1938 secular stagnation thesis is to drive the commercial banks out of the savings business. What would that do? It would make them more profitable, if that is desirable. It would raise the real rate of interest. It would raise the ratio of real output to inflation.
Savings flowing through the nonbanks never leaves the payment’s system. Savers never transfer their savings out of the payments system in the first place, savings never leave the payment’s system unless holders hoard currency or convert to other national currencies, e.g., FDI. There is just an exchange in the ownership of pre-existing deposit liabilities in the banking system, a velocity relationship. Where do you think velocity has gone since 1981?
Savings have become increasingly impounded and ensconced in the payment’s system (a global problem). Contrary to Daniel Thornton, an increase in bank CDs adds nothing to N-gDp.
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