The Fed's too slow
By Scott Sumner
There are a number of weaknesses to using “central planning” in the implementation of monetary policy. Today we see another example—slow decision-making. Whereas markets move at lightening speed, committees of bureaucrats tend to move quite slowly. In 2008, that slowness created a deep recession. I don’t expect that outcome this year, but policy has recently been falling “behind the curve”.
Take a look at this FT graph showing the probability of various policy paths in 2019:
Notice that as recently as March 2019, interest rate futures markets were expecting no change in rates during 2019. At the same time, other financial markets were showing a great deal of optimism. Stocks were near record highs and the labor market was extremely strong. Inflation had been running only slightly below the Fed 2% target. Monetary policy was roughly on course.
Just 2 months later, there are signs that the equilibrium interest rate has fallen sharply. The markets now expect a number of rate cuts this year, and yet despite that anticipated policy “easing”, expectations for growth and inflation seem to be falling.
A naive observer (i.e. 99.9% of pundits) would interpret this picture as follows. In March, there was no expectation that the Fed would ease policy in 2019. Two months later, markets believe that President Trump will succeed in getting the Fed to enact the monetary stimulus that he has been calling for.
In fact, almost the opposite is true. One should never interpret the stance of monetary policy from the level of interest rates. A cut in interest rates may indeed reflect easier money, if associated with faster expected NGDP growth. But it can also reflect tighter money if the central bank is responding too slowly to a fall in the equilibrium interest rate. In this case, the latter interpretation is more likely (albeit not certain), given the recent performance of the markets.
This is why we should never have given central banks the responsibility of targeting interest rates. It’s the original sin of modern central banking. Instead, central banks should target (market) NGDP growth expectations and let markets determine interest rates. Only markets can keep up with fast moving changes in the equilibrium interest rate—bureaucrats are simply not up to the job.
President Trump will likely get the lower rates he’s been asking for, which only goes to prove the old maxim “be careful what you wish for.”
PS. Let me explain the “albeit not certain”, which appeared in this post. All judgments about monetary policy are provisional. Markets provide the best guess based on current information, but will be wrong on many occasions. As new facts come in, market participants continually revise their forecasts. It’s entirely possible that the Fed will be right and the markets will be wrong regarding the path of rates in late 2019. But if I were a betting man . . .