Expressing confidence weak inflation will eventually rise again, Federal Reserve Bank of Cleveland President Loretta Mester said Wednesday the U.S. central bank remains on track for raising rates in the next few months.
Noting that Fed policy isn’t on a “pre-set path,” Ms. Mester said “if incoming economic information supports my forecast, I would be comfortable with liftoff in the first half of this year.” Because Fed policy actions affect the economy over a long period of time, the central banker said the Fed will need to act before it has fully achieved its job and price mandates.
One of the reasons for the Fed´s “conservatism” is the totally conventional notion that monetary policy impacts the economy with long and variable lags (“over a long period of time”). What´s the reason for this “convention” (which is broadly international in scope; “appealed” to by central bankers in disparate corners of the world, both among developed and developing/emerging economies)?
I believe Milton Friedman´s “fingerprints” are all over the “convention”. In the late 1950s, in Congressional Hearings and in his 1959 Program for Monetary Stability, Friedman emphasized his empirical findings of the existence of L&V lags, which applied to all sorts of government policies, including fiscal policy.
I speculate that the main reason Friedman tried to instill the L&V lags idea was to constrain policymakers in their “lust” to fine tune the economy, something he regarded both as dangerous and distortionary.
More recently, the frequent appeal both by analysts and policymakers (like Loretta Mester cited above) to L&V lags may be a way to cover up the fact that the preferred “target” of monetary policy – the FF rate – in reality is not a good indicator of the stance of monetary policy.
Relatively recent work done by Woodford and others show that what affects aggregate demand (AD) or NGDP are the expectations of future changes in monetary policy. If so, lags in the effect of monetary policy should be negligible or nonexistent!
There´s an abundance of empirical evidence for that:
- Which was the developed country least affected by the “Great Depression”? Ans: The UK. Why? It was the first to ditch the gold standard (1931). That´s an expansionary monetary policy (MP).
- Why was it that between March 1933 and April 1937 the S&P essentially tripled (in addition to deflation turn into inflation and industrial production, which had dropped by 52% between the August 1929 peak and March 1933, rose by 52% in just four months to July 1933 and had more than doubled by April 1937? Ans: In March 1933 FDR took the US off gold, devalued the dollar and established a price level target.
- Why did AD in the US plunge in the third quarter of 2008, as did commodity prices, industrial production and inflation itself? Ans: The Fed had been indicating for some time that monetary policy would be tightened (despite the fall and then low (2%) in April 2008) FF rate). This tightening was both reflected and magnified by the strong appreciation of the dollar relative to all currencies in the second half of the year.
- Why was it that between March and October 2009 the S&P went up by 35% (as did commodity prices)? Ans: QE1, which was introduced in March 2009, signaled an “easing” of MP (despite “zero” rates). And note that long yields didn´t fall (as Fed officials stated was their intention), On the contrary, they went up by more than 100 basis points!
The world is in fact awash in evidence against the L&V lags ideal (which makes me wonder why Tony Yates chose “longandvariable” for his blog name). Take the recent experience of Japan or Switzerland, for example.
What Loretta and many of her colleagues are in fact saying is that “expect monetary policy to tighten”. It will be no “normalization” but a bona fide tightening of MP! The consequences will not be nice (in fact, the “rest of the world” is already experiencing those effects).