Minutes from the Federal Reserve’s most recent policy meeting feature a fascinating debate over the latest economic data and their implications for the Fed’s future interest rate decisions. Some members of the Federal Open Market Committee (FOMC) warn that, with unemployment at or below current estimates of the long-run “natural” rate, additional interest rate increases will soon be needed to avoid a costly overshoot of inflation above its two percent target. Other Committee members counter that, with inflation still running noticeably below target, aggressive rate increases would work counterproductively, to slow inflation further and possibly choke off the economic expansion.
Only time will tell which side in this debate proves right. In the meantime, however, the debate itself deserves comment. For it illustrates the value of open, dispassionate discussion in a well-functioning democracy. It also reminds us of important lessons from monetary history, which continue to be relevant today. Finally, the debate points to yet another reason why the FOMC would benefit from following a simple monetary policy rule.
Observers should be impressed by the FOMC’s willingness to discuss all sides of an important policy issue. Before joining the Federal Reserve, current Chair Janet Yellen and her predecessor, Ben Bernanke, were distinguished scholars and teachers. Although both have developed strong positions of their own, both have also drawn on their academic experience by encouraging Committee members to air opposing views. In welcoming challenges to their opinions, Yellen and Bernanke provide important examples of how virtuous leaders behave. Americans need these examples right now, to help us remember that fear of open debate is a hallmark of tyrannical, fascist and communist regimes. Our far superior liberal democracy draws much of its strength from the willingness of all citizens, but especially public officials, to hear and acknowledge opposing points of view.
Digging into the details of the FOMC’s debate reminds us, as well, of important lessons from economy history. Participants who warn that low unemployment today raises the risk of higher inflation in the future are organizing their thoughts around the idea of the Phillips curve, which describes an inverse relation between those two variables. One lesson from history, however, is that while data do often support the existence of a statistical Phillips curve, its fit is not nearly strong enough to serve as a fully reliable guide for monetary policymaking. The limitations of the Phillips curve approach became clear, for example, during the 1970s, when chronically high unemployment was accompanied by rising, not falling, inflation. Today, we may be seeing something similar: unemployment is below 4.5 percent, yet inflation continues to run below the Fed’s long-run target.
In fact, as other participants in the debate point out, inflation has been below target for the past eight years. If one accepts Milton Friedman’s famous dictum, summarizing historical experience that “inflation is always and everywhere a monetary phenomenon,” it is difficult to escape the conclusion that, despite an extended period of very low interest rates, Federal Reserve policy over this period has been insufficiently, not overly, accommodative. This echoes another lesson from the past. Milton Friedman, Anna Schwartz, Allan Meltzer, and Karl Brunner all concluded, likewise, that very low interest rates during the 1930s accompanied, and indeed were the product of, monetary policy that was consistently too restrictive.
All FOMC members, however, correctly note that because of the “long and variable lags” that Friedman and Schwartz saw between monetary policy actions and their effects, the key question now is whether enough stimulus has been applied most recently to bring inflation back to two percent. Thus, FOMC members also correctly judge, on page 10 of the Minutes, that “in determining the timing and size of future adjustments to … the federal funds rate, the Committee should assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.”
Ironically, adopting and following a monetary policy rule – a step that most FOMC members have rejected – would be an ideal way of implementing this “data dependent” approach to monetary policymaking. With unemployment so close to the natural rate, any such rule would determine a pace for future rate increases based entirely on the speed with inflation appears to be returning to target. John Taylor’s famous rule with its coefficient of 1.5 on inflation, for instance, requires every 0.2 percentage point rise or fall in inflation to be met by a 0.3 percentage-point increase or decrease in the federal funds rate. Following the Taylor rule would thereby allow the FOMC to react appropriately to incoming news on inflation. But by officially adopting that rule, FOMC members would also make clear that, despite healthy debates over the state of the economy, they all agree that bringing inflation back to two percent is their singular long-run goal.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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