The Fed’s Next Step

Now that the Federal Reserve has ended its massive bond-buying programs, will it take the next step towards re-normalizing its policies and signal that interest rates will soon be on the rise? The Federal Open Market Committee will answer this question on Wednesday, when it releases the policy statement at the close of its two-day meeting. For debate at that meeting will surely revolve around whether the Committee should change the language in that policy statement by removing its long-standing promise to continue holding short-term interest rates near zero for a “considerable time.”

Indeed, individual FOMC members have already weighed in on both sides of this debate in interviews and speeches given over the past several weeks. Those who would prefer to retain the “considerable time” phasing for at least a while longer point, first and foremost, to the recent behavior of inflation, which continues to come in noticeably below the FOMC’s two percent target. This argument is one that no serious economist should dismiss. For, as Milton Friedman famously said, “inflation is always and everywhere a monetary phenomenon.”

Since the Federal Reserve, as our nation’s central bank, controls interest rates and the money supply, an immediate implication of Friedman’s dictum is that the Fed and the Fed alone is also responsible for controlling inflation. Historical experience shows us how much is at stake here. During the 1970s, high inflation inflicted considerable damage on the American economy. But the Great Depression of the 1930s—which was the focus of Friedman’s most famous work, with Anna Schwartz—reveals that low inflation and especially outright deflation can be costlier still, particularly when it is unexpected. Thus, the Fed needs to chart a middle course, avoiding serious errors on both sides.

As a matter of fact, the graph below suggests that the FOMC pulled back by too much, too soon, in late 2009 and 2010, when it allowed growth in the M2 money supply to decline precipitously. With this mistake, the Fed itself probably generated, however inadvertently, much of the slow inflation—and at least some of the sluggish real economic growth—that we have seen in the years that followed. The more “dovish” members of the Committee are quite right to want to guard against a repeat of that mistake.

But it is equally important to consider the risks on the other side. As the graph also shows, further policy stimulus allowed money growth to bounce back sharply in 2011 and 2012. Since then, the rate of M2 growth has declined somewhat, but it continues to run at a quite healthy pace. Drawing on Milton Friedman’s dictum, and looking at current rates of money growth around six percent, FOMC members should have confidence that inflation will return to their two percent target even if real GDP continues to grow at four percent annually. Indeed, the acceleration in the growth rates of both real GDP and employment that we have seen in 2014 may well be the product of the substantial monetary accommodation displayed so clearly in the figure.

Even acknowledging these very encouraging signs of renewed strength in the U.S. economy, some FOMC members have suggested that it might be fine to allow inflation to temporarily overshoot the two percent target, to make up for all the past misses on the downside. But while there is some sense in that idea, others are correct to argue against it. For once inflation does rise above target, it becomes all too easy for expectations of continued high inflation to become embedded into prices and wages, as firms seek to protect their profit margins and workers seek to protect their real incomes from the corrosive effects of that inflation. Another costly recession—probably not as bad as the one we just lived through, but one that is costly nonetheless—might then be necessary just to bring inflation back down to where it should be.

Thus, after weighing both sides of the debate, it becomes clear that the wisest and most prudent approach is simply to keep inflation moving back towards target, so that it returns to two percent without overshooting. Most analysts, both inside and outside the Fed, recognize that successfully achieving this goal will require interest rates to rise towards the middle of 2015. And recent readings, both on the growth of the money supply and on the impressively building strength of the economy more generally, suggest that these rate increases might have to occur even sooner. By dropping the “considerable time” phrase from its policy statement, the FOMC can most effectively signal that it, too, has growing confidence that the American economy is back on track.