Stop Targeting Interest Rates

The Fed seems to be following the new Keynesian orthodoxy.   It appeared to promise to keep interest rates near zero through 2013.    But the reality is subtly different.   What the Fed actual did was predict that the economy will be depressed for the next few years, which, its says, will justify keeping interest rates low.

I suppose it could be worse.   The Fed could have promised to create sufficient monetary disequilibrium to raise interest rates despite the depressed economy.

The Fed's version of new Keynesian monetary policy is to try to keep the core CPI growing 2% from wherever it happens to be.   If the CPI is expected to rise more slowly than 2%, then they lower their target for short term interest rates in a series of modest, periodic steps.   (It worked great from 1984 to 2007.   They seem to be longing for they day when the economy quits being so stubborn and accommodates itself to their preferred policy approach.)

What is the problem?   What happens if their series of modest decreases in interest rate reach zero, and the CPI is still expected to grow less than 2%?     The orthodox new Keynesian approach is that  the Fed should commit to keeping interest rates at zero for an extended period of time.     The Fed hasn't quite reached zero, and began paying interest on the reserve balances banks keep at the Fed to try to keep interest rates slightly higher. (Apparently they like .25%, though very short T-bills and the overnight lending rate have been even lower.)    Still, they have been promising to keep them there for an extended period of time.    (And if the approach of keeping interest rates at zero for an extended period of time would work, why shouldn't keeping them at slightly above zero for an extended period of time work as well?)

What is new?  The Fed now says it will keep short term interest rates at near zero through 2013.

How is this supposed to work?   According to the new Keynesian orthodoxy, when the economy begins to recover, this commitment to keep interest rates at (near) zero despite economic growth will create higher inflation.  Looking at the situation now, that higher inflation, starting at some future time, implies a higher average inflation rate starting now.   And so the real interest rate over the long term falls.   The lower real interest rate stimulates spending on output, and that starts the recovery.    Implicit in this approach is for inflation, and expected inflation, to rise above the 2% target.   Rather than he price level being expected to rise 2% from wherever it is now, it would be expected to rise more than that.

The problem with this approach, according to new Keynesians, is that the Fed's commitment may not be credible.   When the economy actually recovers, the Fed might raise interest rates to head off the inflation.  In other words, they will keep  the price level rising 2% from wherever it is.    Predicting this, the expected inflation rate doesn't rise, and so the decrease in real interest rates doesn't materialize.    And so, the gambit fails.

From this perspective, the Fed's promise to keep interest rates near zero through 2013 rather than just saying, "an extended period of time," creates more of a commitment.

Unfortunately, the Fed did not say that it will keep interest rates low even after the economy recovers so that higher inflation will be created.   Instead, they just said that they expect the economy to remain slow for the next two years, and so, the interest rate will remained pressed against the zero bound.   If some miracle occurs, and the economy beings to recover, they leave open the possibility of raising interest rates, presumably so that the price level will be expected to rise 2% from wherever it happens to be.

It is time to accept that this new Keynesian approach is a failure.   Give up on inflation targeting.   Give up on interest rate targeting.   Yes, it seemed to work very well during the Great Moderation, but it was not robust in the face of a financial crises.

If the price level is on a stable growth path, then inflation or disinflation are slight deviations from that path.   Avoiding inflation or disinflation is keeping to the growth path, when things go well.  

And it is true that if there is an aggregate supply shock, manipulating short term interest rates to try to reverse the resulting inflation or disinflation and get the price level back to its previous growth path will do more harm than good.   It involves creating monetary disquilibrium to distort interest rates so that real expenditures will change enough to force prices off their changed trajectory, reversing a change in the price level that was just the arithmetic consequence of the changes in the money prices of the particular goods with changed supply conditions.

But a large decrease in money expenditures on output leaves the economy in a state where avoiding inflation or disinflation is not the same thing as keeping the price level on a stable growth path.  And, of course, the problem isn't that the price level has shifted to a lower growth path.   The problem is that money expenditures have fallen to a much lower growth path, and prices and wages have failed to fall nearly enough to clear markets.   Output and employment are growing a bit slow, but the problem is that the levels are way below any realistic estimate of capacity.

Creating expectations that prices will continue to rise 2% from wherever they are now interferes with getting prices and wages low enough so that real expenditure will recover despite the decrease in real GDP.    If poor sales result in pricing strategies that raise prices less than that target, then the Fed does have an excuse for taking action.    But apparently extending the period for which the the Fed promises to keep interest rates low isn't enough action to reverse the decline in spending on output.

How is it that a promise to keep short rates low as long as the economy is depressed is supposed to raise spending?   Is it because this will lower long rates?    But to the degree firms and households share the view of the Fed that the long rates are lower because the depressed conditions will extend further into the future, how is this supposed to motivate more expenditure now?      All the Fed is doing is calming fears that the Fed will raise rates despite poor economic conditions.

Worse, each decrease in actual inflation is a downward shift in the target growth path of the price level.    For example, suppose money expenditures miraculously returned to the growth path of the Great Moderation over the next year and  everything was reversed--output and employment recovered to their previous growth paths and so did the price level.    With the price level being about 2% below its trend, that would require  4% inflation over the next year.     But the Fed is claiming that they want to keep the CPI from rising more than 2%!      The fact that the price level has grown more slowly that 2%  over the last several years would require the Fed to raise short term rates to reverse that miracle recovery!

What the Fed needs to do is commit to getting GDP (money expenditures on output) back to a target growth path.    They should not make any commitment to  any kind of interest rate.   Interest rates, particularly short term ones, should change to reflect current conditions.    The current conditions are such that they should be below zero.   Without radical change (privatization of hand-to-hand currency) nominal interest rates aren't going lower than the cost of storing federal reserve notes.   But they can get that low.    In particular, the interest rate on reserve balances at the Fed should be negative.  (The Fed should charge banks for holding reserves.)    And when the economy does recover, short term rates should rise--not held low to keep a commitment from the past.

Now, the Fed must commit to do something if necessary get GDP back to target besides letting short term rates fall to their true lower bound.   And that is purchase as many government bonds as necessary to get GDP to target.    (And the other side of the count is to sell all that is necessary to reverse if it is overshot.)    There is not much point to purchasing securities whose yields are at the true lower bound--slightly negative.   If it were really true that the Fed only held T-bills, it would be possible that additional purchases would drive the yields of even those with one year maturities to slightly less than zero.    However, the Fed has long held government bonds with longer terms to maturity.  (The notion that the Fed only does open market operations with T-bills is a textbook myth.)    And so, the Fed needs to commit to move up the yield curve as necessary. If one maturity has its rates driven to zero (or slightly less,) then purchase slightly longer terms to maturity.

Oddly enough, by simply saying that it will do this if necessary, the result could be GDP rising rapidly to target, while short and long term rates rise, and the Fed has to sell off securities.   The demand for money, and especially for reserve balances, may fall.   Further, as short term interest rates rise, the Fed can and should raise the rate it pays on reserve balances!  

What about inflation?   The Fed should target the growth path of GDP.   Sure, the Fed and the rest of us, should hope that prices rise only modestly and that real output and employment recover rapidly.   But the Fed should say that what happens to prices is irrelevant.   If production and employment stay depressed, and the increase in GDP is mostly due to higher prices, then they will accept that.   The price level should be allowed to adjust when productive capacity deviates from trend.   And if the productive capacity of the economy has dropped tremendously over the last four years, then the unfortunate consequence of that is a higher price level.

It is time for something new.   Stop Targeting Interest Rates!