The Fed has more than just “some explaining” to do

Narayana Kocherlakota writes “The Fed Has Some Explaining to Do”:

My forecast is that the Fed will remain reluctant to raise rates until inflationary pressures are much stronger, at which point it will feel compelled to move at a faster pace than four times per year. This is similar to Chicago Fed President Charles Evans’s suggestion that the central bank should wait to raise rates until core inflation reaches 2 percent. If prices start rising at that rate, the Fed will be right to put a lot more weight on inflationary concerns than on downside risks.

Charles Evans’ suggestion has been practiced in the past.

Back in mid-2003, when inflation was far below 2%, the Fed adopted forward guidance (“FG”). In the Minutes of the August 2003 meeting we read:

The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.

In January 2004, the message changed to:

With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation.

In May 2004, in the meeting before the first rate hike, the message became:

With underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.

The chart illustrates the period:


The FF Target rate started moving up when core inflation reached 2%, just like Charles Evans suggests at present.

However, note that at the time, NGDP was somewhat below the trend level path. The chart indicates that forward guidance was sufficient to take it back to trend, with core inflation at 2%


Unfortunately, at present, the environment is very different. Today, NGDP is way below the original trend level, in which case, even if (big if) inflation is brought closer to 2%, the level of nominal spending will still remain far below any reasonable trend path.


To “ignite” the economy, and lift it from the depressed state it´s in, the best alternative is not to keep “fiddling” with interest rates, but to change the target to an NGDP Level target.


Alan Blinder thinks the interest rate trajectory defines the stance of monetary policy

Michael Darda to Scott:

Alan Blinder in today’s WSJ, arguing, as some Fed officials have, that it’s not the start/timing of the initial rate hike/tightening that matters, it’s the trajectory. This is just incredibly wrongheaded in virtually every respect. If the Fed is overlooking a passive tightening in monetary/financial conditions and a concomitant drop in the eq. short rate and then compounds it by actively tightening instead of easing, the “trajectory of short rates” will be very shallow indeed. The “path” of short rates was “only” 25 bps in Japan in 2000, “only” 50 bps in Japan in 2006/7 and “only” 50 bps in the EZ in 2011. And the outcomes were all consistent with monetary policy failure.

Memo to Blinder: Never reason from an interest rate path.

Scott comments:

This is a very important point. In the three episodes mentioned by Darda, the trajectory of interest rates was extremely flat, after the initial increase. And yet in all three cases monetary policy was far too contractionary, and in all three cases the country (or region) again fell back to the zero rate boundary. The Fed may avoid that mistake, but it won’t be because a flat interest rate trajectory means easy money. I’d guess that about 90% of interest rate movements reflect the condition of the economy, and 10% reflect Fed policy.

Blinder’s right that the future path of policy is very important, but wrong in assuming that the future path of interest rates tells us anything useful about the future path of policy.

Which reminded me of 1993-95, At that time, the Fed chose a “steep” path for the FF target rate. Was policy “tight”?

The nominal side:


Where it is hard to assign a “policy role” to the FF rate. After all, inflation fell while the FF rate was “dead” and stopped falling when the FF rate increased rapidly!

Now look at what went on with NGDP. It is clearly much more relevant to what happened to inflation.

The real side:


RGDP growth and the fall in unemployment pick up when NGDP growth rises (despite the rise in the FFT) . What the Fed successfully did was to put the nominal economy back on track after the 1990/91 recession and importantly, with a permanently lower rate of inflation. The real economy says “thanks”!

Note: Apparently, the Fed was also successful in “tracking” the equilibrium interest rate!

The FF target rate is just a placebo, but it can be toxic if too much is ingested at a low level of stamina

From Yellen´s most recent speech, it is clear that these “doctors” are not worth their pay. They are only concerned with prescribing a placebo (FFT)! Maybe it´s harder to provide nominal stability at an appropriate level (“dose”). And we know that “prescription” is good because it has done wonders for the patient in the past!


But Yellen expressed confidence that the recovery remains intact — even if it is not as robust as Fed officials themselves once thought. And that would be enough for the Fed to begin reversing nearly a decade of easy money.

Because of the substantial lags in the effects of monetary policy on the economy, we must make policy in a forward-looking manner,” Yellen said in prepared remarks. “Delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy.

From the charts below, it appears that if they want to play around varying the “dosage” of placebo as they were used to, they first have to get the “patient level of stamina UP”!