The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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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?

January 31, 2006 in Federal Reserve and Monetary Policy | Permalink


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Tracked on Feb 1, 2006 11:32:12 PM


But what if it resulted in recession like 90 or 01 instead? The question would seem to be how sensitive is the economy now relative to those earlier times, and how much and how long an overshoot follows. Is there any economy out there to pick up from imports, construction, and housing? Certainly not manufacturing.

Posted by: Lord | January 31, 2006 at 02:42 PM

I can't figure why Academic Economists and Fed analysts are staying mute on the Fed's decision to drop reporting of M3. I've brutalized an excerpt on relative clarity from a recent talk by intellectual Noam Chomsky to remind you of that: "Relative clarity matters. It is pointless to seek a truly precise definition of "inflation", or any other concept outside of the hard sciences & mathematics, often even there. But we should seek enough clarity at least to distinguish inflation from two notions that lie uneasily at its borders: aggression & legitimate resistance."
Why study Macro Economics if tenured Academics stand mute to this latest assault by vested interests on the field's single most important term?

Posted by: bailey | January 31, 2006 at 07:51 PM


"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."

I could live with that as long as vigilance against debauchery of the currency was maintained, real jobs (not McJobs) started re-appearing and a real effort to promote a durable domestic economic base was made.

Is that asking for too much these days??

Posted by: The Nattering Naybob | January 31, 2006 at 10:59 PM

David: I don't disagree with much of what you said, but I do think that the issue of the time lag needs to be addressed. You identify a monetary policy "success" in reducing inflation and inflation expectations in the middle of 1995. Fair enough.

But my point is slightly different: given the economy's response lag to interest rate changes, those "successful" inflation effects were presumably due to the interest rate increases that happened in early and mid-1994. The subsequent tightening in late 1994 and early 1995 had had very little chance to affect the economy by mid 1995, and so I would argue that those latter interest rate increases were not beneficial, and thus probably unnecesary. In fact, the Fed presumably realized that themselves, given that they very quickly undid the last few hikes.

Thus the central problem in my mind is the inherent difficulty posed by the long time lags between interest changes and any impact on the economy. There's no easy solution to that problem... but it does make me think that there's a reasonable possibility that today's interest rate increases will be unwanted by the time they actually start to have a real impact on the economy in 6 or 12 or 18 months.

Posted by: Kash Mansori | February 01, 2006 at 08:25 AM

Frankly, i think you all may be missing the point........real interest rates on a global basis are exceptionally low at this stage of the cycle.

Hence, the risk isn't overshoot, but that they are undershooting!

that's why all the talk about pause has been inappropriate, mkts are bullish equities, and selling bonds looks like the best mkt trade this year!

Posted by: andres | February 01, 2006 at 11:23 AM


Dave points out "No matter how you choose to define monetary tightness, however, it is easy to see the justification for a policy adjustment during that period."

And Kash points out, its the latencies that make the "wash out" period difficult to gauge.

For example: even the quarterly % increases in M3 during 05 of 1.5% to 2.3% seem benign. Its the acceleration rate of M3 that is alarming:

Q2 to Q1 = 12.5%; Q3 to Q2 = 81.1%; Q4 to Q2 = 62.4%; Q3+Q4 to Q1+Q2 = 82%

Where is this sea of green going to gravitate? And thats just our currency, other currencies (RMB, yen & Euro) are experiencing the same effect.

We are in uncharted and nebulous waters with hindsight implements to navigate. The central banks can only go based on past experience and hope for the best.

Posted by: The Nattering Naybob | February 01, 2006 at 01:32 PM

Nattering, I am curious since we now are in a world economy. If we agree that the dollar is the currency of last resort, and that interest rates have been kept artificially low buy foreign bank purchases, what have the corresponding M3 figures been like in yen and euros? Has there been expansion there? Or has the monetary policy been so tight world wide that the fed can afford to be loose with M3?

Posted by: jeff | February 01, 2006 at 03:34 PM

Lord -- You are, of course, right. I might have told the story of the 1999-2000 episode instead, and the outcome would look a lot less pretty. One difference is that there was an outright inversion in 2000, but the big difference is that relatively tight monetary policy was combined with other stress points. That may not be much comfort now because a couple of those -- an energy price shock and "investment overhang" in particular -- have analogs in the current period. However, it still is unclear how that episode might have read after-the-fact absent 9/11.

Kash -- The problem with the long and variable lag story is that is provides no guidance at all for determining when enough is enough. One of my main points is that, operating in real time, the central bank has to keep moving on with the program until the objective is cleearly met. That may mean that some amount of overshooting is inevitable, but I am suggesting that is not the worst outcome we can think of. In addition, when it comes to inflation expectations, I'm not convinced that the lags are so long.

On the M3 issue, I'm afraid that I don't have much to say beyond what I have said before -- I just don't believe it provides a reliable guide to the effective stance of monetary policy. It is interesting that the dominant view of those who do take it seriously is that monetary policy is too loose, not too tight.

Posted by: Dave Altig | February 02, 2006 at 07:31 AM

Dave, interesting. You've inspired a new suggestion: why not also subtract the 5-10% of cash that's hoarded in pillowcases & behind walls? Some time back I acknowledged & apologized for my ranting on this but I find microanalysis of this most important topic irrational & exasperating. Here's a little ditty from Shelley ("Prometheus Unbound") on irrational man:
"The good want power, but to weep barren tears.
The powerful goodness want: worse need for them.
The wise want love; and those who love want wisdom;
And all best things are thus confused with ill."
Have a great day.

Posted by: bailey | February 02, 2006 at 09:56 AM

I would not complain. Given the quality of data and the variety of theoretical economic frameworks that the Federal Reserve has to consider, you have to recognize that managing monetary policy is by nature inexact.

Posted by: Scott Peterson | February 02, 2006 at 03:38 PM

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