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The Fed: Extraordinary Measures in Ordinary Times


The Fed: Extraordinary Measures in Ordinary Times

March 19, 2014

Economic performance continues to improve and move toward normal, while the Fed’s monetary policy is far from normal. The economy is in its fifth year of expansion, the unemployment rate has fallen faster

than projected, and the financial crisis is becoming more distant. The rationale for the Fed’s forward guidance aimed at artificially suppressing real rates for years to come is dissipating. The Fed has been slow to acknowledge this.

Even with the Fed’s relatively hawkish Policy Statement following this week’s meeting and the FOMC members’ updated forecasts that moved up their assessments of when it would be appropriate for the Fed to hike rates, monetary policy remains far too stimulative.

The Fed seems to have lost sight of what normal monetary policy should be, and is ignoring the historic pitfalls of excessive focus on short-term conditions and monetary fine-tuning. The rate hike cycles of 1994 and 2004-2006 provide valuable lessons and shed important light on the Fed’s forward guidance.

In response to solid economic growth, beginning in February 1994 the Fed hiked rates sharply, from 3 percent to 6 percent in a year’s span. This rate hike episode is widely considered the most effective monetary tightening in Fed history, even within the Fed. It paved the way to the robust economic performance and low inflation in the second half of the 1990s, and bolstered the Fed’s credibility. Yet it was accomplished virtually without forward guidance. 

The Fed surprised markets with an intermeeting rate hike, a 50 basis point increase at a scheduled meeting and another 75 basis point hike. Bond yields rose sharply to the initial Fed rate increases, almost entirely in real terms as inflation remained stable around 3 percent. The stock market held its strong gains from 1991-1993. The Fed emphasized low inflation as the best foundation of healthy sustained economic expansion, and did not try to manage market expectations. 

Economic growth slowed temporarily in early 1995 and then reaccelerated. The most interest-sensitive sectors, including housing, durable goods consumption, and business investment led the reacceleration, despite high real rates. Employment and real wages rose sharply.

Despite this picture-perfect soft landing, the Fed pursued a nearly opposite monetary policy during its 2004-2006 tightening cycle. The Fed was extremely cautious about raising rates, as Greenspan feared a repeat of the 1994 bond yield increases. It waited until core inflation nearly reached 2 percent and the economy was strong until it began hiking rates and repeatedly emphasized that the rate hikes would be “measured”. 

The Fed’s excessive effort to manage market expectations effectively was a “first generation” forward guidance, even before the term became part of monetary policy lexicon. It worked all too well: bond yields barely rose while inflation rose faster, and real yields fell. Ironically, Greenspan lamented the lack of bond market selloff as a “conundrum” even though he had contributed to it. 

The Fed’s go-slow rate hikes contributed to unintended economic and financial distortions—the bubble in housing and the unsustainable mortgage and household debt explosion—that led to the financial crisis.

Strikingly, even as the Fed acknowledged mounting inflation pressures amid strong real growth in 2005, Policy Statements and Minutes of FOMC meetings barely mentioned the growing excesses in the mortgage market, rising household debt, or sharply rising share of residential investment in GDP.

Several lessons from the 1994 and 2004-2006 rate hike episodes stand out. First, it is critically important that real interest rates be allowed to fluctuate. Excessive monetary ease that constrains real rates generates distortions and misallocates resources. Rising real interest rates reflecting economic expansion are healthy, and do not harm growth. Real rates were very high when economic growth reaccelerated in 1995. They were even higher when the economy recovered strongly from recession in 1983.

Second, whether forward guidance is efficient or leads to bad outcomes depends critically on what the forward guidance is.

The Fed has established targets for the unemployment rate over which it has little control, a glaring error. The Fed has modified its targets, triggers, and thresholds so frequently that its forward guidance is simply a manifestation of discretionary monetary policy. As the Fed emphasizes its policies are data dependent. 

In its latest updated quarterly forecasts, the FOMC members moved up their expectations of rate hikes, but they suggest maintaining monetary stimulus even when the economy and labor markets have fully recovered to capacity. 

Now, many FOMC members forecast the appropriate Federal funds rate to center around 1.75 - 2.25 percent at year-end 2016, while the average forecast is 2.4 percent, a significant jump from its last quarterly forecast. But that is when the Fed forecasts the unemployment rate to be 5.2 - 5.6 percent and inflation 2 percent. 

Forecasting a real funds rate barely in the positive territory—still implying monetary stimulus—when the Fed has fully achieved its dual mandate is inappropriate and sends out the wrong message. Some Fed members have even remarked that when “full employment” is achieved, a 0 percent real funds rate will be needed to combat ongoing economic headwinds. This is economic nonsense, even if one speculates that the natural rate of interest is below 2 percent.

The Fed needs to change the focus of forward guidance. Trying to suppress real rates far into the future poses risks as the economy and labor markets continue to improve. Present Fed policies are adding unnecessary “ambiguity risk” to economic decision making, domestically and globally. This harms performance while distortions and longer-run inflation risks are being ignored. It can be expected that with the tailwinds of massive monetary stimulus, inflation will rise above the Fed’s 2 percent target.

Forward guidance should be transformed into a transparent strategy for how the Fed will normalize monetary policy, including a strategy for reducing its bloated balance sheet and raising interest rates at a pace commensurate with economic improvement. Being more precise and following a rule that is within its scope would be a big step forward for monetary policy and would improve economic performance.


Mickey Levy is a member of the Shadow Open Market Committee.

For more on this topic, see Achieving Normalcy in Monetary Policy.

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