
I often use the analogy of steering a bus when discussing monetary policy. A rise in the equilibrium or “natural” rate of interest is like a bend in the road. The Fed must adjust its policy rate to keep the economy from going off into a ditch. But this analogy only goes so far.
The Fed’s most important duty is not to adjust interest rates to changes in the natural rate, rather it’s to reduce instability in the natural rate of interest with a better monetary policy regime. To return to the bus analogy; it’s as if the bus driver both steers the bus and changes the path of the road.
In late 2021, the Fed moved away from average inflation targeting. The uncertainty created by this policy shift caused the natural rate of interest to become much more unstable than otherwise. That was by far the Fed’s biggest policy mistake, not its failure to raise rates in a timely fashion.
Milton Friedman favored increasing the money supply at a constant rate. This is not because he believed that velocity was stable; indeed his research showed it was often rather unstable. Rather he believed that the volatility of velocity was caused by unstable monetary policy. Friedman hoped that if the Fed stabilized the growth rate of the money supply, then over time the velocity of circulation would also become more stable. In other words, he wanted to straighten the road. In this monetarist framework, the instability of velocity plays the same role as an unstable natural rate of interest plays in the Keynesian interest rate approach to policy.
I am unimpressed with most of the discussion of what went wrong with monetary policy. I see pundits obsessing over steering mistakes, and overlooking the far more important problem of how the Fed took a fairly straight road and made it much more twisty by abandoning FAIT. That was the Fed’s biggest policy mistake.
The Fed isn’t just making bad decisions; it is making it harder for Fed official to make good decisions. The Fed is now the Fed’s own worst enemy, creating a macroeconomic environment where it’s much harder to know where to set interest rates or the money supply.
In 2021, I thought that the Fed had adopted something like level targeting. I was wrong.
READER COMMENTS
Matthew Opitz
May 6 2022 at 8:32am
Where should the Federal Funds rate be right at this moment in order to straighten the road (reset inflation expectations around 2%, resume FAIT and restore credibility that the Fed is following that policy, etc.)? 2%? 3%? 4%? 5%? Monday-morning quarterbacking is fine and all, but if you were in the hot seat, how would you restore credibility in FAIT right now and salvage the situation as best as possible? (And let’s take it as a given that just promising FAIT with a really really earnest voice won’t be enough in this moment because your predecessors screwed up and drained whatever credibility there was).
Matthew Opitz
May 6 2022 at 8:37am
And by the way, I know how you will be tempted to respond: “Conduct rhetoric/open market operations/interest on reserves sufficient to restore a 5% NGDP growth path.” Sure, fine, but how much open market operations and/or adjustment on interests on reserves would be needed for that? Would you do weekly adjustments upwards by 25 basis points until your favored NGDP prediction market started showing 5%?
Scott Sumner
May 6 2022 at 12:26pm
You said: “And by the way, I know how you will be tempted to respond: “Conduct rhetoric/open market operations/interest on reserves sufficient to restore a 5% NGDP growth path.” ”
No, that’s not my response. I’d prefer 3.5% NGDP growth right now. I don’t know where interest rates should be, I’d let the market decide that. Policy should clearly be tighter—there are many ways of doing that. Start by dramatically shrinking the balance sheet.
The appropriate interest rate with FAIT is not the same as the appropriate rate without FAIT.
Thomas Lee Hutcheson
May 7 2022 at 5:31am
Points of clarification:
How do we know that the Fed no longer aims for average inflation of 2% over the long run from a) misestimating the setting of its policy instruments — ST interest rates, QR purchase/sales, IOR — to achieve that goal. And If so, what goal did they replace it with and when?
How (how to figure out which settings of which instruments + rhetoric) should the Fed achieve the 3.5% increase in NGDP given that it does not yet have a NGDP futures market?
Scott Sumner
May 7 2022 at 10:32am
Powell said the Fed does not intend to offset periods of above 2% inflation with periods of below 2% inflation.
Todd Ramsey
May 6 2022 at 10:30am
OK, they failed at FAIT. It’s an opportunity for you to help make lemonade.
Powell probably reads Sumner: March 2020 has your fingerprints all over it.
Keep pushing for NGDPLT and NGDP Futures! Your advocacy can help turn a temporary failure into a forever success.
Todd Ramsey
May 6 2022 at 12:08pm
Maybe the Fed didn’t actually abandon FAIT.
Maybe they failed because it’s more difficult in practice than in theory.
In hindsight, 2022 Q4 looks like an overshot. But in real time, the 5 Year TIPS spread was only greater than 3% for 10 days during the quarter.
That’s why we need a better real time guide than the TIPS spread. That’s why we need your proposed thick, liquid NGDP futures market. Don’t give up! Keep your eyes on the prize!
Scott Sumner
May 6 2022 at 12:27pm
“Maybe the Fed didn’t actually abandon FAIT.”
No, they abandoned it, at least as most people interpret the term “average”.
Todd Ramsey
May 6 2022 at 6:30pm
I think the difference is semantic.
To use dictionary definitions, the Fed did not “cease to support” or “give up completely” on FAIT. Your Econlog post of March 16 shows the prediction of longer run inflation by the median Fed Governor is 2%, consistent with a FAIT approach.
The Fed appears to be performing poorly in executing FAIT — it’s more difficult in practice than in theory— but that’s different from “giving up completely”.
Scott Sumner
May 6 2022 at 11:08pm
No, a 2% inflation rate in the long run is not consistent with their FAIT policy. It’s consistent with the previous inflation targeting policy. Inflation has recently been extremely high, and thus needs to run under 2% in order to average 2% over time.
Todd Ramsey
May 7 2022 at 10:13am
OK, I understand now, you are right.
I still believe they had good intentions but overshot in Q4 2021 because targeting inflation is difficult in practice.
Which comes back to my original point: I hope you will keep leading the charge for an NGDP futures market, so the Fed can monitor results in real time. You have made and are making positive change.
milljas
May 8 2022 at 12:32pm
Which prices would you actively monitor to see if the bus was navigating better and the road was straightening? We don’t have an NGDP futures market, what is the best proxy that can be seen live? It does appear some commodity price baskets have stopped going up…. Those baskets may be impacted from other factors….
Comments are closed.