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March 24, 2005
What Those Rate Hikes Mean
Brad DeLong makes a lot of sense with this statement...
The Fed is focusing much more on non-wage causes of increasing prices, and is very concerned not to get into a position where fighting inflation requires large and sudden interest rate increases in the context of a financial system that is much more fragile than we would like.
... but slips a bit here (emphasis added).
Better higher unemployment now than even a chance of running into a conflict down the road between risking a financial crisis and letting inflation accelerate.
The problem I have with this comment is that it confuses an increasing funds rate with "tight" monetary policy. The following is from an essay that appeared in the Cleveland Fed's 2001 annual report:
... “a balance between the quantity of money demanded and the amount the central bank supplies” requires the federal funds rate to adjust roughly in alignment with changes in real—that is, inflation-adjusted—returns to capital... Stable monetary policy—a stance that induces neither inflationary nor deflationary pressures, that seeks to avoid both artificial stimulation and inadvertent retardation of real economic growth—requires, paradoxically, active management of the federal funds rate. It is hard to imagine a coherent view of monetary policy without first disentangling defensive rate adjustments that maintain policy neutrality from rate changes that are, in fact, designed to go beyond neutral and stimulate the economy.
In the current context, that last part would read "stimulate or restrain" the economy. The essay goes on:
... it [is] easy to forget, or to fail to appreciate, two essential facts. First, market interest rates—especially real (inflation-adjusted) rates—have a life of their own, independent of monetary policy. Second, when events conspire to move inflation-adjusted market rates, maintaining a given funds rate requires the Federal Reserve to alter the pace at which it injects liquidity into the economy. The latter observation means that when circumstances in the rest of the economy change, failing to move the funds rate is likely to alter the stance of monetary policy by default...
Simply put, maintaining a neutral policy stance—and conditions in which the economy’s natural resiliency can emerge—requires the federal funds rate to fall in light of the market interest rate pressures typifying economic downturn. The requirement is, of course, symmetrical: The softness of capital returns that accompanies recessions generally reverses in recovery. Consequently, the funds rate typically must rise in an expansion, lest the failure to adjust induce an inflationary policy.
The funds rate will have reached an appropriate and sustainable level when, first, the outlook is consistent with the Committee's economic goals and, second, the slope of the term structure of interest rates is approximately normal, as best as can be determined... the neutral policy rate depends on both current and prospective economic conditions. Accordingly, the neutral rate is not a constant or a fixed objective but will change as the economy and economic forecasts evolve.
I speak only for myself here, of course, but I say the most straightforward explanation of recent and currently prospective funds rate increases can be found in an interpretation that stresses the concept of moving toward neutrality. In this view, higher funds rates are fully consistent with a stable, or even falling, unemployment rate. The implication that the Committee is trading off unemployment for restraint with respect to inflationary pressures is, in my opinion, simply mistaken.
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