Steer the bus AND straighten the road
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.