I just saw a film with that title, about a guy drifting around lost in the middle of the Indian Ocean on a small sailboat. Today I’m going to show you just how contractionary current money policy actually is. But not based on the Sumner/Bernanke “NGDP growth is the optimal way to measure the stance of policy” argument that almost no one seems to buy, (not even Bernanke.) No, I’m going to show you that policy is currently ultra-tight using the Fed’s own criteria. I will show that the Fed is violating the law without even knowing it. I will show that if you start with current policy, and make two changes that are each unambiguously expansionary, you end up with a policy that is so hawkish that it clearly violates the Fed’s dual mandate.
A few weeks back I did a post advocating that the Fed abandon one of the two thresholds in their forward guidance. Many people misunderstood the post, because they misunderstand the guidance. So let’s be clear:
The Fed promises not to raise rates as long as unemployment is above 6.5% and inflation is below 2.5%. (That means they have the option of raising rates or not raising rates when unemployment is below 6.5% and/or inflation is above 2.5%. It’s a negative promise, to refrain from something, not a promise to affirmatively do anything.)
I said drop the employment threshold. At first glance you would think that is a hawkish move, as you ignoring more “dovish” part of the dual mandate. In fact, it’s just the opposite. The scenarios where they would be allowed to raise rates become even fewer. Now they can raise rates when unemployment is 6% and inflation at 2%. Under my proposal they would not be able to do so.
After the post, Fed officials began discussing the possibility of lowering unemployment threshold to 6.0% or even 5.5%. That would be a move in the direction I recommended, but my proposal is obviously much more radical, and importantly much more dovish.
So I hope we can all agree that my proposal would be a substantial move in the dovish direction. In today’s Wall Street Journal there is another proposal that would also make policy substantially more dovish:
Officials also have mixed views about the benefits of lowering the 6.5% unemployment threshold.
At a July meeting, for instance, they worried moving the threshold would hurt their credibility and undermine their effectiveness, according to meeting minutes. At a September meeting, minutes showed, some favored keeping the 6.5% threshold but explaining in more detail how long they would wait to raise rates after it was crossed. Fed officials have also considered adjusting their 2.5% inflation threshold to make clear they don’t want it below 1.5%.
Inflation is currently running at about 1.2%, hence a 1.5% inflation floor would immediately force the Fed to adopt a significantly more stimulative monetary policy. That’s another move that pushes policy in a substantially more dovish direction.
And where would we end up after the two changes discussed above? We would end up with a promise to keep inflation within a 1.5% to 2.5% range. In other words we would end up with a single mandate, 2% inflation target. At a time when unemployment is far above the Fed’s estimate of the natural rate of unemployment, focusing like a laser on 2% inflation becomes an ultra-hawkish policy. Indeed it would be a clear violation of the Fed’s dual mandate to address both inflation and employment. It would be clearly ignoring the employment side of the mandate.
Let me be clear that I am not saying that current Fed policy is as ultra-hawkish as the 2% inflation target that ignores unemployment, which I’ve just described. No, I’m not saying current Fed policy is that ultra-hawkish. I am saying it is far, far more hawkish than that. If I walked into an FOMC meeting and proposed the two changes discussed above, I’d be laughed out of the room. Richard Fisher would ask if I had just arrived from Zimbabwe. There is no way the Fed would even consider doing both of those changes at the same time. And yet if they did they would end up with a policy that is still so contractionary that it would be in violation of the law.
The Fed is currently so far from home that they don’t even know which way to go, just like Robert Redford on the middle of the Indian Ocean with his damaged sailboat.
Lost at sea.
PS. Lot’s of people are asking me for comments on a new Fed paper that discusses NGDP targeting. I’ve already addressed all the anti-NGDP arguments in my Mercatus paper on the subject, and dozens of blog posts. I see no reason to respond to the same arguments over and over. The rest of the profession needs to respond to the arguments that we (market monetarists) are making. I don’t see them doing so. It’s their job to catch up; we are way ahead of the consensus on this issue.
BTW, in addition to all the reasons already discussed for not worrying about NGDP revisions, the new Philly Fed estimates of “NGDPplus” provide another reason why data revisions are not a barrier to NGDPLT.
HT: Frank McCormick
Update: I should add that things are slightly more complex than I suggested; the 1.5% to 2.5% channel has a little bit of price level “catch-up” built in for the current undershooting of 2%, so there is a small degree of price level targeting added on to inflation targeting. But fundamentally it’s a 2% inflation target. It’s the Fed saying we’d like inflation above 1.5% and below 2.5%