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January 31, 2006
In Defense Of "Overshooting"
No matter what comes of today's FOMC meeting, or those that immediately follow, there is no question that the funds rate has come along way since June 2004 when the current spate of rate hikes commenced. In a post last week at Angry Bear, Kash Mansori suggested that we have seen this movie before:
One pattern that we’ve seen is that, during periods of monetary tightening, the Fed has tended to overshoot and tighten too much, necessitating a relatively quick reversal of policy...
During each of the past three episodes of monetary tightening, the Fed quickly realized that they had gone too far, and were forced to reduce interest rates after only a short time. In 1989 and 1995 they reversed course on monetary policy after only 4 months, and in 2000 they reversed course after 7 months...
... such policy mistakes are probably more the rule than the exception among central bankers. But it does add to my worries for the economic outlook in 2006. Is there any reason to think that the Fed won’t overshoot again this year, and find itself soon wishing that they hadn’t raised interest rates quite so much?
That 1995 episode is instructive, so let's explore the record in a little more detail. To begin with, I tend to define policy as being "tight" or "easy" more in terms of the relationship between the funds rate and longer-term interest rates than in the level of the funds rate itself. The reasons for this are spelled out in some detail here, but a rough translation would be something like "flat-yield curve, tight; steep yield curve, easy." One simple way to get a look at the contour of the yield curve is to compare the funds rate to the yield on 10-year Treasuries:
By this measure, policy did become relatively tight in 1994-95, although the pace was much slower than just looking at the funds rate alone would suggest. Furthermore the bulk of the action took place late in the game, and as a result of the FOMC standing pat on the funds rate as the 10-year yield was falling.
No matter how you choose to define monetary tightness, however, it is easy to see the justification for a policy adjustment during that period. The following is a picture of Blue Chip inflation expectations over the same period of the graph above:
That is a picture of success. But, even so, did policy overshoot? Did the FOMC take the funds rate too high, and wait too long to move in the opposite direction as inflation expectations abated and long-term interest rates fell?
Perhaps, but as Kash fairly points out, it is difficult to be too precise in real time, and the central bank appears to have erred on the side of containing expectations and inflationary pressures, as good central banks are wont to do.
Did this caution come at a cost? Again, perhaps. Here is the record of GDP growth:
The growth rate of the economy in 1995 was indeed weak in the context of the surrounding years. In particular, GDP growth in the first half of the year was woeful. But the policy enacted in 1994 and 1995 arguably set the stage for the years that followed, years characterized by better-than-average growth and stable inflation.
So let me ask this question. Suppose that, in retrospect, we find that the FOMC's current round of rate hikes went a little too far. Suppose that we find that fourth-quarter 2005 GDP growth was not an aberration, but the first of several quarters of sub par economic expansion. But suppose further that we find that the extraordinary sequence of energy-price shocks over the current recovery did not bring a persistent increase in the overall inflation trend. And suppose we find that, following two or three quarters of soft economic activity, GDP expanded at rates between 3 and 4 percent for years after.
Would you complain?
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