Hoisted: Monetary Policy: Try Overshooting for Once!
The excellent Ryan Avent, from four years ago:
Monetary policy: Try overshooting for once!: "DAVID BECKWORTH points us to Janet Yellen...
...vice chairman of the Federal Reserve, who points, in turn, to the obvious:
[R]esource utilization rates have been so low since late 2008 that a variety of simple rules have been calling for a federal funds rate substantially below zero, which of course is not possible. Consequently, the actual setting of the target funds rate has been persistently tighter than such rules would have recommended. The FOMC's unconventional policy actions--including our large-scale asset purchase programs--have surely helped fill this "policy gap" but, in my judgment, have not entirely compensated for the zero-bound constraint on conventional policy. In effect, there has been a significant shortfall in the overall amount of monetary policy stimulus since early 2009 relative to the prescriptions of the simple rules that I've described.
As I've said before, if the Fed's target interest rate had been at 6% for most of the past three years while a standard policy rule was indicating that a rate of 2% was appropriate, no economic writer in the country would have wasted words wondering what had gone wrong with the American economy. The Fed reduced its interest-rate target to approximately zero in December of 2008, and for most of the time since policy rules have indicated that rates should in fact be considerably lower. That could have meant trouble if the Fed had done nothing more. Or it could have meant no trouble at all if the Fed had quickly pivoted to a different target—had indicated, for instance, that it would expand its balance sheet until the economy was on track to quickly reattain a previous price or NGDP level. But neither of those things happened next.
What happened next was a most curious thing. The Fed decided that if it couldn't reduce short-term rates any more, thanks to the zero lower bound, that it could try instead to reduce long-term rates. This it has successfully done, both through purchases of long-term Treasuries and through a quasi-commitment to keep short-term rates low for an extended period. Now, this policy is indeed stimulative, and it provided a boost to the economy that would not have occurred had the Fed stayed its hand when rates hit zero. But without the ready measuring stick of the federal-funds-rate target, the Fed has been unable to stick to a clear and sensible stabilisation rule. Rather, it has opted to push on a variety of policy levers in an effort to maximise real growth subject to a 2% inflation limit, which has been surprisingly binding. In other words, when recovery loses momentum such that inflation begins dropping, the Fed acts: by changing its language, or changing the term structure of its debt holdings, or expanding its balance sheet. When it then appears that inflation may rise to 2% or so, it immediately ceases expansionary action.
The problem with this is that it is a fairly oblique way to approach stabilisation at the zero lower bound. The Fed has lost the ability to reduce short-term nominal interest rates. It has not lost the ability to influence expectations and, therefore, the real, inflation-adjusted interest rate. At the zero lower bound, the real interest rate is the negative inflation rate. The Fed's determination to set a hard ceiling on inflation at 2% effectively puts a hard floor in the real interest rate which, sadly, remains above the market-clearing level.
The result is a very slow recovery and lingering high unemployment. And the result of that is that there is very little upward pressure on prices and wages. And the result of that is that any little shock that comes along quickly translates into reduced expectations and a rising real interest rate, which is, of course, contractionary. The choice to stick hard by the 2% target means that virtually all of the risk is downside.
That seems like a screwy way to make policy....
One wants to scream, try overshooting for once. Try overshooting for once! Try it! Try pushing inflation up above 2% for a while and see if you can't generate enough growth to soak up some slack in the economy, thereby greatly reducing the risk that any little headwind that comes along knocks the economy back below stall speed. Try it! There is no way that a year of 3% inflation is bad enough to justify this pitiful hiccuping recovery. Try overshooting!
