Blissful Ignorance

Janet Yellen:

And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy. In addition, the level of short-term interest rates consistent with the dual mandate varies over time in response to shifts in underlying economic conditions that are often evident only in hindsight.

For these reasons, the range of reasonably likely outcomes for the federal funds rate is quite wide–a point illustrated by figure 1 in your handout. The line in the center is the median path for the federal funds rate based on the FOMC’s Summary of Economic Projections in June.1 The shaded region, which is based on the historical accuracy of private and government forecasters, shows a 70 percent probability that the federal funds rate will be between 0 and 3-1/4 percent at the end of next year and between 0 and 4-1/2 percent at the end of 2018.2

The reason for the wide range is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted. When shocks occur and the economic outlook changes, monetary policy needs to adjust. What we do know, however, is that we want a policy toolkit that will allow us to respond to a wide range of possible conditions.

The range of reasonably likely outcomes for the FF rate is so wide it´s useless.

Blissful Ignorance

One property NGDP targeting (in fact NGDP LEVEL Targeting) is that it is the appropriate framework for “all seasons”, i.e. you don´t need to keep tinkering with monetary policy. In addition to keeping the central bank from mishandling supply shocks, it keeps the central bank from generating demand shocks, which throws both inflation and real growth in the same direction, up as during the “Great Inflation” and down as in the “Great Recession”.

9 thoughts on “Blissful Ignorance

  1. “But if I can’t tinker, why become a Fed board member?”
    [sarcasm, though I think it’s what most Fed members really think]

    • As a practical matter, I doubt very much that nominal income path targeting would imply ‘set it and forget it’ policy rate setting. Policymakers would presumably make their own judgments on how policy settings would affect future nominal income paths and decide how fast they would like (projected) nominal income to converge on the target path, balancing the desirability of rapid convergence against the heightened uncertainties that a fast approach might entail (to cite one example of what real-world policymakers do).

      • Come again? How is it that rising short-term rates imply an inverted curve “in about a year”? Are you taking the bond rate as exogenous? If so, why?

      • Here’s why I said they are projecting an inverted yield curve. Figure 1 above shows the median projection from the FOMC members of the Fed funds rate to be about 1.75% in about a year. Using forward rates to estimate what the 10 year T will pay in 12 months gives about the same answer. Based on the approx. 75 bps drop after the December 2015 hike, I think the curve would invert if the Fed hikes 125 bps from here over the next 12 months. That said, I seriously doubt that they’d keep hiking, so I think they’ll avoid an inverted yield curve. But at this time, I can’t imagine why they think they’ll get to hike the FFR by 125 bps and that concurrent with that amount of tightening the 10 year T would rise above current market expectations. If they want the rate on the 10 year T to rise, they need to stop paying IOR.

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