The Fed is too inertial

In previous posts, I’ve argued that the Fed’s interest rate target should be adjusted daily, set at the median vote of the FOMC. Today provides a good example of why this reform would improve policy.

In recent weeks, the natural rate of interest has fallen sharply, and significant parts of the yield curve have inverted. US equity prices have declined over the past few days on worries about global growth. TIPS spreads are also falling, as are oil prices. (These latter two are usually correlated at high frequencies.)

[We don’t have a direct measure of the natural rate of interest.  But when market interest rates fall sharply during a time of declining NGDP growth expectations, it’s a good sign that the natural rate of interest is also falling.]

By themselves, none of these data points are decisive. But policy must be made in a world of uncertainty, based on the best information available. The data we have suggest that the Fed’s interest rate target should be reduced.

The Fed will probably not cut rates on Wednesday. This is not because they believe a rate cut would move them further from their policy goals, rather it reflects the inertial nature of policymaking. Target interest rate changes are treated as major events, which require weeks of careful deliberation.

It would be better if interest rate targets were de-emphasized. It should be no big deal to raise rates one day, cut them the next, and then raise rates the following day. That’s how things work in most asset markets; it is the Fed that is the exception. The Fed’s inertial process of policymaking makes policy more procyclical than what we would have with a more nimble, more market-based system.

Don’t be sluggish.  The Fed needs to Make Policy Changes Routine.



22 Responses to “The Fed is too inertial”

  1. Gravatar of John Hall John Hall
    27. January 2020 at 13:05

    What parts of the yield curve are inverted? The 10yr-3mo and 10yr-2yr spread are both positive, albeit close to zero.

  2. Gravatar of rayward rayward
    27. January 2020 at 13:46

    Not sure about this. I have to deal in the real world of business borrowers, for acquisitions, expansion, whatever, and uncertainty in borrowing costs can be a deterrent. But here’s the truth in today’s market: getting more than a five year commitment for an interest rate is costly – borrower’s have to buy it, and it’s not cheap. Would more frequent changes in rates make matters worse or better? I could argue both ways, but frequent changes could avoid the shock of infrequent changes.

  3. Gravatar of ssumner ssumner
    27. January 2020 at 14:25

    John, The 3 month/5 year is inverted.

    Rayward, You are confusing more frequent changes in policy rates with more frequent changes in market rates. Don’t conflate those two issues.

  4. Gravatar of Lorenzo from Oz Lorenzo from Oz
    27. January 2020 at 15:14

    But isn’t inertia what bureaucracies do?

    The need for officials and underlying to demonstrate (using the term loosely) “value add” is surely a persistent drag against adopting market-based monetary policy.

    (The reading I have been doing for a book project has made the problems of bureaucratisation particularly salient.)

  5. Gravatar of Lorenzo from Oz Lorenzo from Oz
    27. January 2020 at 15:21

    Scott, have you seen this?

    I thought it was because the growth rate of NGDP has largely paralleled the growth rate of output …

  6. Gravatar of Benjamin Cole Benjamin Cole
    27. January 2020 at 16:45

    I think this is correct, that central-bank policy should be adjusted continuously.

    By the way, the Bank of Japan meets monthly.

    Perhaps the FOMC could agree on a monetary-policy formula at their august and grave meetings, something similar to a Taylor rule, that would adjust daily.

    So recent market signals, such as the decline in stock markets and the lowering of interest rates, would result in automatic adjustments (easing) of monetary policy.

    In this world, I still think automatic tax cuts on wage income is probably the best policy response to any slowdown in the economy.

  7. Gravatar of Benjamin Cole Benjamin Cole
    27. January 2020 at 16:57

    OT but in the ballpark…

    The Federal Reserve recently released its Beige Book, with its latest iteration and sometimes shrill commentary that the US is defined by “worker shortages.”

    Pimco, the world’s largest bond manager, is the latest institution to comment that the global economy is defined by capital gluts, a view also espoused by former Fed chair Ben Bernanke.

    Okay then, capital glutz and worker shortages.

    If our current tax system relies upon taxes on wages and taxes on capital, does not the current situation call for an adjustment, that is lower taxes on wages and higher taxes on capital?

    At the least, if worker shortages have persisted for several years, shouldn’t there be screaming from the mountain tops for lower taxes on wages?

  8. Gravatar of Trevor Adcock Trevor Adcock
    27. January 2020 at 18:05

    Ben what’s wrong with a capital “glut”, that just means interest rates are low. Low interest rates seem like a good thing to me, the future matters too.

    A worker shortage just means wages are too low. Shortages are caused by prices higher than the market clearing level. Businesses think there is a worker shortage, because they are monopsonists. A monopsonist always thinks there is a shortage, since marginal revenue from an additional worker is greater than the wage they are paying.

  9. Gravatar of bill bill
    27. January 2020 at 18:14

    Very well said. I’d add that the 5-year inflation breakeven is down 14 bps in the last two weeks as well.

  10. Gravatar of Postkey Postkey
    28. January 2020 at 00:55

    Inflation in the ‘pipe line’?

    “ The table below summarizes key numbers. The pattern is much as in recent months, although the American money growth acceleration was interrupted by a moderate 0.4% M3 increase in December. All the same, the US money growth acceleration has been persistent enough to deserve highlighting. Buoyant money growth is normally associated with asset price gains and balance-sheet strength, and hence with above-trend growth in demand. With the US stock market up by about a quarter in the last year and house prices also moving ahead, the argument is strengthened. However, leading indicator indices are as yet signalling only trend growth in the USA and elsewhere. . . .

    Despite the almost double-digit annual money growth rate in the USA, it is too early to be 100% confident about a forecast of above-trend growth. However, another quarter or two of broad money growth at recent rates would justify a strong forecast of that sort. With national output already somewhat above trend according to most estimates, above-trend growth would imply a significantly positive output gap in early 2021 and meaningful upwards pressures on inflation. Given the lags before inflation deteriorates, President Trump may enjoy a very favourable economic background in the November election“

  11. Gravatar of Benjamin Cole Benjamin Cole
    28. January 2020 at 03:21

    Trevor Adcock:

    BTW, Joe Adcock for the old Braves was an under-rated player.

    I largely agree with you on “worker shortages.”

    Indeed, when I went to college, back in the era of programming with Fortran cards, we were taught in economics there is no such thing as a “shortage,” only where the supply and demand lines cross. The concept of a “shortage” was something dreamed up by do-goody pointy-heads.

    Still, if the US wants to increase the supply of labor, sharp reductions in wage taxes might help. This is sound economics, and why not apply less taxes on productive people?

    On capital, the world is water-logged with capital, while aggregate demand is so-so. The cut in the US capital gains tax has resulted in a jump in stock buybacks. US corporations are cash-rich, with no place of invest.

    The sensible place to raise taxes is on capital—this might be different from the 1960-70s, when capital was often scarce, and baby boomers entering the labor markets.

    Unfortunately, politics and ossification define macroeconomics today. Whether or not it makes sense to raise taxes on capital, or labor, is not the question. The question is, “What is your politics or orthodoxy?”

    Actually, for the US. I prefer taxing not capital or labor, but retail sales, property, pollution, Pigou, fuel and imports.

  12. Gravatar of rayward rayward
    28. January 2020 at 05:25

    My first comment was meant to emphasize the difference between policy rates and market rates because most folks don’t know that they differ. Why isn’t business borrowing and investing more at these historically low rates? Because market rates, while they may appear to be low today, are subject to increases and banks won’t commit for longer than three to five years (presumably due to the risk of rising market rates). Does business want to borrow today at the risk of the interest rate rising significantly in three to five years?

    As for Fed inertia, won’t the level of inertia increase the closer we get to the election? After all, the Fed doesn’t want to give the impression that the Fed is trying to help (or hurt) Trump’s re-election chances? Better to act now than wait until this summer or fall.

  13. Gravatar of P Burgos P Burgos
    28. January 2020 at 07:45

    “ The Fed’s inertial process of policymaking makes policy more procyclical than what we would have with a more nimble, more market-based system.”

    Isn’t the reason for the inertia a need to build relative consensus within the institution and to protect its political independence?

    Also, have Fed policy makers modeled how they should react to a global pandemic? Surely keeping the economy on an even keel is an important part of responding to a pandemic.

  14. Gravatar of Brian Donohue Brian Donohue
    28. January 2020 at 10:52

    Very good post. This would be a great idea to implemeent.

  15. Gravatar of ssumner ssumner
    28. January 2020 at 11:11

    Lorenzo, Yes, but bureaucracies change over time. I recall when we were told that bureaucracies wouldn’t go for a specific objective like an inflation target.

    Burgos, It’s not a question of responding to a global pandemic (I don’t know how either). It’s a question of responding to a fall in the natural rate of interest.

  16. Gravatar of ssumner ssumner
    28. January 2020 at 11:18

    Lorenzo, The correct answer to his question is “monetary policy”.

  17. Gravatar of Thaomas Thaomas
    28. January 2020 at 11:51

    @B Cole

    Automatic stabilizers are OK — maybe transfers to S&LG might be included — but we have not seen what would happen if the Fed just “did what it takes” to keep inflation rising at a target average rate, i.e. price level targeting or NGDP level targeting.

    I’d prefer that fiscal policy be guided by NPV considerations.

  18. Gravatar of Miguel Navascues Miguel Navascues
    28. January 2020 at 12:05

    I don’t know if your proposal will translate to more uncertainty and volatility. Just a thing to added at the very anemic aptitude of capital for investment – as Ben Cole remember us.
    More uncertainty & volatility, more speculation, more Income to financial sector, more buybacks, etc. Are you sure that higher volatility doesn’t translate to all the interest rate curve? I don’t see it clear.

  19. Gravatar of Thaomas Thaomas
    28. January 2020 at 12:14

    “I’ve argued that the Fed’s interest rate target should be adjusted daily”

    I think this can be misleading. The Fed should not have an interest rate target at all. Probably its ST interest rate instrument should be adjusted more frequently (why not daily?) and with less fanfare. If it wishes to publish its estimates of what ST interest rate instrument is likely to be if it follows a target of keeping the price level rising by 2% per year, fine, so long as it does not let fear of its predictions turning out wrong affect the rates it actually sets.

  20. Gravatar of Benjamin Cole Benjamin Cole
    28. January 2020 at 17:23

    Thaomas: I would argue we have seen what happens when central bank does what it takes to maintain a policy or target. That happened when the Swiss National Bank committed to maintaining a fixed exchange rate on the Swiss franc.

    They were in fact successful, but ended up buying $100,000 of bonds per Swiss resident.

    Can the US Federal Reserve commit to buying $33 trillion in global bonds? And would even such a spending Bonanza result in higher aggregate demand within the United States?

    I believe the record shows that quantitative easing is rather weak tea. Moreover, government, authorities, officials and media have lost credibility. Nobody believes them anymore—-see Scott Sumner’s comments regarding President Trump.

    When the next recession comes, I hope we see a holiday on FICA taxes.

  21. Gravatar of John Hall John Hall
    29. January 2020 at 10:39

    Looks like the 10 year – 3 month curve just inverted again.

  22. Gravatar of Thaomas Thaomas
    30. January 2020 at 11:19

    @ B Cole
    An automatic adjustment in the FICA is fine (although a VAT and not a wage tax ought to finance SS and Medicare trust funds).

    I would not want the Fed to pre-commit to any particular amount, class or asset to buy (not there is anything wrong with dollar denominated foreign assets of creditworthy countries, or time limits to the program. Whether QE is weak tea or not depend on how long the bag is left in the cup, right? We do not know how much or little QE would be required if the commitment were to a PL or NGDP target because it has never been tried. It could be far less than 2009-2010 if it were know that the “beatings will continue until morale improves.” 🙂

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