If the past is any guide, many Americans will celebrate the New Year by making resolutions—to start a new diet, for example, or exercise more—that they’ll abandon before January is through. Healthy living requires a plan for the long run—and the determination to stick to that plan, even when doing so imposes inconveniences and costs in the short run.
Successful monetary policymaking also requires a plan. The financial crisis and the severe recession of 2007-09 forced the Federal Reserve to hold interest rates at extraordinary low levels and to expand its balance sheet enormously through three massive bond-buying programs known as “quantitative easing” to help the economy recover. But with U.S. economic performance finally returning to normal, the Federal Open Market Committee under Chair Jerome Powell has articulated a clear strategy for gradually bringing interest rates and the size of the Fed’s balance sheet back to more normal levels as well. At the start of this new year, several forces—including political criticism, financial market volatility, and a slowdown in economic growth elsewhere in the world—have emerged to pressure the Fed to abandon these normalization plans. If the economy is to remain healthy in 2019 and beyond, however, Powell and his FOMC colleagues must stay determined to stick to their original plan.
The FOMC, as expected, raised interest rates again, to a range between 2.25 and 2.50 percent, at its December 2018 meeting. The Committee has increased the federal funds rate nine times since late 2015 after holding it near zero for the seven-year period following the financial crisis of a decade ago. Economic projections released immediately after the meeting reveal that most FOMC members place the longer-run level of the funds rate to be somewhere in the 3 percent range. This means that the Committee will likely raise rates two or three more times in 2019 to bring them back to their normal, long-term level. Similarly, at the press conference following the December FOMC meeting, Chair Powell emphasized that the FOMC intends to stick to its previously announced plans for reducing the size of its balance sheet by gradually allowing the bonds it acquired during three rounds of quantitative easing during and after the financial crisis to mature without reinvestment. This, too, is necessary to scale back the Fed’s outsized role in the financial markets, allowing bond prices to adjust to balance more efficiently the supply and demand for credit.
The news that Chair Powell and his colleagues intend to bring monetary policy back to normal was not well received. President Trump publicly criticized the Fed’s December interest rate increase before it happened, arguing that it would slow down the rate of U.S. economic growth. And he is correct in making this point. Although the federal funds rate applies only to loans between banks, all other interest rates in the economy move up and down together with the funds rate. This means the Fed’s rate hike will make it harder for American consumers to purchase new homes or vehicles given that borrowing costs are now higher. Similarly, American businesses might hesitate to undertake new investment projects now that their borrowing rates are higher, too. Indeed, history shows that economic growth slows when the Fed increases interest rates, precisely because of the effects that tighter monetary policy has on consumer and business spending.
But while President Trump, facing reelection in 2020, is naturally focused on these short-term effects of monetary policy, the Fed needs to be concerned with the long-term effects as well. History also shows that if the Fed keeps interest rates too low for too long, higher inflation follows. In a recent paper, economist Robert Hetzel describes how, throughout the 1970s, the Fed frequently hesitated before raising interest rates, fearing the economic and political costs of slower economic growth in the short run, only to find that even larger interest rate increases were needed later on to fight against higher inflation. As a result, monetary policy during the 1970s followed a recurrent “go-stop” pattern of excessive ease and tightness that led to both high inflation and economic volatility. In the same paper, Hetzel also describes how, starting in the mid-1980s and continuing through the 1990s, the Fed acted preemptively by raising rates gradually to keep inflation in check even as the economy continued to grow. The result was an exceptional period of low inflation and economic stability that economists call the “Great Moderation.” The contrast between the poor economic performance of the 1970s and the much better outcomes of the 1980s and 1990s underscores that successful monetary policymaking, like a successful diet or exercise routine, requires a plan for the long run and the discipline to stick to it. With their decisions at the December 2018 meeting, FOMC members appear to have remembered the lessons of this historical experience, eschewing the temptation to secure short-run gains in growth at the expense of exposing the economy to even larger long-term costs.
None of this is to say that the Fed should remain on auto-pilot, unresponsive to changing economic conditions. Chair Powell was clear about this, too, in his remarks at the start of the December FOMC press conference. He acknowledged that some “crosscurrents” could complicate the Fed’s plans, including the slower growth in the international economy and heightened financial market volatility worldwide that began to emerge in late 2018. Thus, Chair Powell reiterated that the FOMC’s policy decisions “are not on a preset course and will change if income data materially change the outlook.”
For now, however, that outlook remains quite good. The same projections referred to above show that FOMC members expect inflation to stick close to the Fed’s 2 percent target in 2019, and the unemployment rate to remain below its long-run sustainable level while economic growth runs above it. Against this backdrop of economic strength, Chair Powell and his colleagues at the Fed are right to insist on sticking to their previously-announced long-run plans. By doing so, they will contribute importantly to prolonging the economic expansion. And they may even provide some inspiration to the rest of us, who struggle to keep our own New Year’s resolutions.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee, an independent group of economists who, with the support of the Manhattan Institute and Economics21, meet to comment regularly on the Federal Reserve and its policies.
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