But economic conditions will eventually force its hand
By R.A. | WASHINGTON
LARRY SUMMERS is right; this year's Fed symposium in Jackson Hole was triply disappointing. In the weeks before the gathering, members of the Federal Open Market Committee (FOMC) publicly discussed their worries that the current monetary framework might leave the Fed unable to deal adequately with future slowdowns. They got our hopes up: enough that we published a leader giving the Fed some suggestions for new approaches. But as Mr Summers says, the Fed let us all down. In their public remarks, at least, the FOMC members present expressed little concern about problems with the Fed's toolkit or weaknesses with the current 2% inflation target. Worse, Janet Yellen and Stanley Fischer, the chairman and vice-chairman respectively, used the occasion to tell markets to revise up their expectations of near-term rate hikes. Several of the regional Fed presidents suggested that the second rate rise of the cycle could come as early as the September meeting, while Ms Yellen reckoned that the case for an increase in coming months has strengthened.
The utter lack of urgency regarding monetary reform looks all the more worrying given the hawkish bias at the FOMC. In theory, Fed members could both accept the need for a new monetary framework and believe that current conditions (and the current framework) argue in favour of a near-term rate hike. Given current economic conditions, however, a hawkish stance is an implicit statement that the arguments in favour of reform are without merit.
There are lots of reasons why one might want to tweak the way the Fed does its job, but the focus of most recent reform proposals has been the long-run decline in the global real rate of interest consistent with non-slump conditions. That is: most big economies seem stuck with low real interest rates, even when they're rumbling along close to their potential growth rates. Low real rates create headaches for central banks, because they limit how high central bankers can raise real policy rates without tanking the economy. If central banks are determined to keep inflation low (at or below 2%, for instance) then that also sets an upper limit on how high nominal policy rates can go. And that means that big economies are going to find themselves stuck with near-zero policy rates—and limited room to stimulate the economy—with uncomfortably high frequency.
Ideally, global real interest rates would stop falling and move back to a more "normal" range. But as there is little sign of this sort of reversal, the Fed's best option would seem to be to switch to a target that gives it more room to raise inflation. A higher inflation target—of 4%, for instance—would be one option. Targeting the level of prices or nominal GDP would also give the Fed room to generate catch-up inflation after a slump.
Fed members have clearly understood this critique and these proposals. But Fed members have not only decided not to set a new target. They also remain steadfast in their determination to undershoot the target they've already got. As they have for months, the Fed's hawks continue to note the strength of the labour market and dismiss low inflation as the transitory product of low energy prices and a strong dollar. Yet too-low inflation looks like a chronic affliction. The Fed's preferred measure has been below the 2% target since May of 2012! The latest data show a deceleration in inflation, which clocked in a 0.8% year-on-year in July. Unsurprisingly, both market- and survey-based measures of inflation expectations have been trending downward. Not even the FOMC seems to believe low inflation is transitory. The highest rate of inflation any FOMC member anticipates over the next few years is just 2.1%, arriving by the end of 2018.
This is crazy. Having undershot its 2% target for so long, the Fed could argue that a bit of overshooting is justified so that it hits its target on average, across the whole of the business cycle. It could argue that overshooting is justified as a way to nudge inflation expectations back up. It could argue that, having failed to reach its target for more than four years now, caution demands it hold off on rate increases until inflation is unmistakably on track to reach 2%. But no! Absurdly, the Fed is preparing to raise rates while inflation is both below target and decelerating.
Markets know exactly where this sort of behaviour will lead. Futures prices indicate that through 2019 the Fed's policy rate will remain below 1%. That's 2019: a full ten years after the recovery began, into territory which would make the current expansion the longest in American history. In each of the last three downturns the Fed responded by cutting its policy rate at least 500 basis points. Without a doubt, the Fed will go into the next one unable to cut rates even 100 basis points. The pre-Jackson Hole discussion makes clear that Fed members understand all of these dynamics. They're just not worried about them.
They should be. The reason not to care about this rotten outlook, if you are an FOMC member, is because you have complete confidence in the unconventional tools available. And indeed, the thrust of Ms Yellen's speech was that the Fed's other policies performed adequately during the Great Recession and its aftermath. But this is also too absurd to take seriously. This recovery, while long-lived, has fallen well short of reasonable expectations. Job growth during the first four years of the recovery was dismal, wage growth has been weak throughout, and employment and labour-force participation rates remain depressed. Neither should we expect unconventional tools to be as effective the next time around; long-term interest rates have much less room to fall now than they did in 2009-10, for instance.
The Fed appears to be institutionally incapable of grappling with the challenges posed by a low-rate world. But the low-rate world is probably not going away any time soon. And so institutional paralysis and the reliance on unconventional tools in this low-rate world seem destined to cause a shift in responsibility for the economy away from central banks and back toward elected governments. Not before time, if indeed the best idea the Fed can come up with in this environment is a rate hike.
