This post is perhaps on the wrong blog; there's little if anything in this post that I intend to be speculative or even novel. I've been hearing some talk from laymen about fed policy that makes me think that they are thinking about some things very differently from how I, and I think most economists, do, and I'm writing this post as a guide to a framework that's more in the realm of mainstream economics.
Suppose you're in a car on a stunt track, and you're supposed to go up a ramp and jump over a ravine; you need to be going at least some minimum speed when you get to the top of the ramp or you won't make it across. One thing you would want to do, if you're well below that speed, is to start accelerating well before you get to the ramp. If you put the pedal to the metal hundreds of yards out, and someone criticized this decision on the grounds that if you push the gas pedal as hard as you can now, you won't be able to push it any harder when you close within a hundred yards of the ramp, you would think that criticism was nuts.[1] It would sound exactly as nuts as the complaint that cutting the federal reserve policy interest rate in response to a small slowdown in the economy "uses up ammunition", and that the fed should instead "save up ammunition" for if there's a full-blown recession.
Certainly in every economics model I've seen — and (not quite the same thing), I'm pretty sure that almost[2] every economist is quite confident that this is true — it is not the rate cut that is stimulative; it is the low rate that is stimulative. "Low" will depend on context — indeed, a low rate is typically a sign that policy hasn't been stimulative recently — but from a given starting point, lowering the rate sooner will allow stimulation to accumulate longer; trying to postpone the cut will increase the need for stimulus in the future.
The simplest model, then, with the fewest possible explicit moving parts, is that there is some "neutral interest rate", not known with full precision and subject to influence from noisy external factors, and that policy is contractionary if the policy rate is higher than it and stimulative if the policy rate is lower than it.[3] If policy is stimulative, that will tend to raise the future neutral interest rate, and if it's contractionary it will tend to lower it. Note that the system — at least parameterized this way — is unstable; if you keep the policy rate fixed forever, the natural rate will either find itself above the policy rate, and will then be pushed higher (by inflationary expectations as aggregate demand picks up), making the policy rate even more stimulative, making it move higher even faster, or the natural rate will find itself below the policy rate, and will similarly move ever lower as a deflationary spiral takes hold. If you're making monetary policy by controlling an interest rate, then, you need to move it in response to noise, pushing it above the natural rate when the natural rate gets high and below it when the natural rate gets low.
And this, then, gets me closer to another comment I hear, which is that long-term interest rates are driven entirely by expectations for future short-term rates, which may in some sense be true, and that therefore the fed has complete control of long-term rates, which is in important ways false, at least where we're talking about real interest rates.[4] I recently mentioned to my class that if you want to know how many jobs there will be in the economy next year, ask an economist, but if you want to know how many jobs there will be in thirty years, you should ask a demographer; similarly, in the short run the fed may have a fair amount of latitude, but if it's avoiding both hyperinflation and depression, an interest rate that's too high now implies a lower range of reasonable policy rate options in the future. Expectations about long-term average future real rates should be formulated (almost) entirely on the basis of economic phenomena, and not on some institutional analysis of the fed or psychological analysis of its governors.
[1] You'd be right.
[2] This is the "Dean almost", wherein I have an excessive aversion to making categorical statements about large groups of people; you can probably drop the "almost".
[3] To be clear, all the standard models could be reduced to this sort of model; they would differ in how (much) outside factors affect the neutral rate, and how stimulative or contractionary deviation from that rate is.
[4] If the fed has a credible inflation target, then control of long-term real rates and control of long-term nominal rates are basically the same.
Tuesday, February 25, 2020
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