Monetary Policy is Not About Interest Rates: The Federal Open Market Committee has a problem. The problem is not that it raised rates by a scant quarter percentage point in December. The problem is the overall policy framework that led the Committee to take that action. The Committee needs to switch to a framework that is less focused on a particular time path of interest rates, and more focused on the achievement of its goals.
The FOMC’s current policy framework goes back to at least mid-2013. It can be defined by two key words gradual and normalization. Both words refer to the level of monetary accommodation. In terms of the target range for the fed funds rate, the word “gradual” is generally interpreted by those who watch the Fed closely to mean about four increases of a quarter percentage point. The word “normalization” is generally interpreted to mean “returning to about 3.5 percent”.
To be fair: the evolution of the macroeconomy does enter into this framework. But it only matters to the extent that it might lead the FOMC might tweak the pace of interest rate increases up or down. The main mission is still defined by those two key words: gradual and normalization.
Unfortunately, this mission of gradual interest rate normalization seems increasingly inconsistent with the FOMC’s being able to achieve its macroeconomic objectives over the medium-term. In terms of the FOMC’s employment mandate: the fraction of those aged 25 to 54 who have a job remains well below what Americans should view as “normal”. The nation needs above-trend growth for several more years to cure this problem - and that’s certainly not my forecast for 2016.
The above is somewhat arguable (because some see the low labor force participation rate as either desirable and/or beyond the reach of monetary policy). But the inflation picture is clear. Inflation has run below the FOMC’s target of 2% for almost four years. Like many others (including, as the December minutes indicate, the FOMC’s own staff), I don’t expect it to return to target for several more years.
Both the inflation situation and (perhaps more arguably) the employment situation seem to call for more monetary stimulus, not less. But the FOMC is set on gradual normalization of interest rates. This framework seems grounded in a troubling aversion to both low interest rates and interest rate volatility. Markets have taken note of the FOMC’s aversion to unusual levels of monetary stimulus. We see clear signs that investors have increasing doubts about the FOMC’s ability/willingness to keep inflation as high as 2% over the long run - especially during periods of low growth.
The Committee needs to change its basic policy framework. Monetary policy is not about targeting the level and volatility of interest rates. The FOMC needs to have a framework in which the fed funds rate (and its other tools) are much more responsive to its medium-term forecasts of inflation and employment shortfalls. Markets would then have to adjust to the possibility that interest rates might have to change rapidly, at any time and in either direction, if the FOMC believes that change is necessary to achieve its macroeconomic objectives more rapidly.
And, yes: this goal-oriented framework would imply that the FOMC should undo its December rate increase. But that’s not my point. No given quarter percentage point move matters all that much in monetary policy. What matters is the overall monetary policy strategy - and the FOMC's is flawed.
If the Committee keeps its current policy framework, I believe that the FOMC is running a significant risk of a persistent decline in long-term inflation expectations. Such a decline would feed into the long-run level of interest rates, thereby reducing the recession-fighting capacity of the Fed, and increasing financial stability risks. Unfortunately, as Japan has shown us all too well, such declines are very hard to undo.
FOMC Press Release on today's monetary policy meeting (no change in rates...).