The Corner

Monetary Policy

The Fed: A Change for the Worse?

This Bloomberg report by Tim Duy (also discussed by Ramesh in an earlier post) makes interesting reading:

For the Federal Reserve, this time really is different. Having learned a hard lesson in the last recovery — don’t tighten monetary policy too early — the central bank is leaning in the opposite direction. In practice, that means the Fed will not just emphasize actual inflation over forecasted inflation, but will also attempt to push the inflate rate above its 2% target. It’s a whole new ballgame.

The Fed’s traditional Phillips curve approach to forecasting inflation, which relies on the theory that inflation accelerates as unemployment falls, was widely criticized during the most recent economic recovery.

The Fed is probably right to think that the Phillips curve has currently lost much of its predictive value. Much of the explanation for that, in my view, in the U.S., at least, can be found in diminished union power and, I suspect, structural labor-market weakness (which can be seen in underemployment as well as unemployment) that, for reasons ranging from automation to offshoring, is far more profound than is widely understood.


No longer are estimates of longer-run unemployment taken as almost certainly indicating the economy is at full employment. Instead, [Fed governor Lael] Brainard said the Fed should focus on achieving “employment outcomes with the kind of breadth and depth that were only achieved late in the previous recovery.” The Fed is going to try to run the economy hot to push down unemployment. . . .

Think about what she is saying. Traditionally, the Fed attempts to reach the inflation target from below, effectively using the unemployment rate to forecast inflation and then moderating growth such that projected inflation doesn’t exceed its target. Brainard is saying the Fed should not tighten policy until actual inflation reaches 2%. Policy lags — the time between the Fed’s actions and the resulting economic outcomes — mean inflation will subsequently rise above 2%. The Fed would thus overshoot the inflation target and then return to the target from above.

Federal Reserve Bank of Philadelphia President Patrick Harker goes even further in a Wall Street Journal interview, saying “I don’t see any need to act any time soon until we see substantial movement in inflation to our 2% target and ideally overshooting a bit.” Expect to see more Fed speakers also saying they want inflation at or above 2% before they tighten policy. Also expect to see something along these lines codified at in a policy statement.

Implicit in that reasoning is the idea that inflation, if when it starts to “overshoot,” can be tamed just like that. History would suggest that’s not how it works.

But also implicit in that reasoning is that what the economy (and employment) needs is interest-rate suppression. While, with government debt as astronomically high as it is, I can see why Washington — in the broad sense of that term — would like to keep rates as low as possible, it would be a mistake, in my view, (1) to overestimate the extent to which ultra-low interest rates will juice up the economy and (2) to underestimate the malinvestment that may now lie ahead, not to speak of the damage to pension funds, retirees, and those who rely on fixed incomes.

I doubt this ends well (then again, that is a standard closing comment to most of my comments on the economy these days).


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