Scott Sumner  

The Fed is not doing its job

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Here's a recent WSJ report on the economy:

Many Federal Reserve officials entered 2015 thinking they likely would start raising short-term interest rates by midyear. That idea got put on ice after a winter economic slowdown, partly attributed to the dollar's rapid rise in previous months.

While the dollar's value is down a bit from its March peak, the Fed's own models show the greenback's drag on the economy is likely to grow in coming months.

This and other factors could prompt some Fed officials to lower their latest growth forecasts, to be released at the next Fed policy meeting June 16-17--and to wait even longer to move on rates.


If we make the highly plausible assumption that the Fed's two-year forward NGDP forecast is also declining, then we can infer that the Fed is not doing its job. Its job is not to adjust its forecasts up or down, but rather adjust its policy so that its longer-term forecast never needs to be revised.

The article also suggests that Janet Yellen is confused about the current stance of monetary policy:

At their March meeting, Fed officials lowered their expectations for U.S. growth to a range of 2.3% to 2.7% this year and next. In December they had estimated a pace as high as 3% for both years.

Fed Chairwoman Janet Yellen attributed some of the March downgrade to the dollar's strength. "Export growth has weakened. Probably the strong dollar is one reason for that," Ms. Yellen said at her March news conference.


There are all sorts of problems here, starting with reasoning from a price change. Price changes are not good or bad for the economy. They have no effect. Instead they are the effect of other deeper forces. If the dollar rose because of monetary stimulus at the ECB and BOJ, that's a bullish indicator for America. If it rose due to tight money at the Fed, that's bearish.

Let's say Yellen is right that the recent increase in the dollar is a bearish sign for the US economy. There's still a problem with her statement. She seems to suggest that the strong dollar is some sort of exogenous shock that unfortunately hit the US, causing the Fed to miss its targets. But if it is in fact contractionary, then the "shock" has been caused by excessively tight monetary policy. A strong dollar in the foreign exchange markets doesn't cause NGDP growth to fall, tight money does.

Inevitably some commenters get confused about what I mean by "tight money". I use the Bernanke (2003) definition, which relies on indicators like NGDP growth. But even if you prefer the more popular New Keynesian (NK) definition, money is clearly getting tighter. The NKs look at the future path of interest rates. In their model an expected increase in the future target interest rate has, ceteris paribus, a contractionary impact today. Indeed the NK model predicts that promises of future interest rate increases will cause the dollar to appreciate, which the Fed believes slows growth and reduces inflation. So even if you don't like Bernanke's unconventional NGDP-based criterion for determining the stance of policy, money has clearly been getting tighter.

The Fed needs to stop looking for mysterious outside forces impacting spending, and begin to realize that monetary policy alone determines the path of nominal spending in the economy. If it doesn't like that path, change the policy. By merely wringing its hands about a slowdown in growth, it is failing to do its job.

PS. I also recommend this article by Caroline Baum, which makes some similar points.

PPS. Here's an even more discouraging statement:

But perhaps Ben should consult Stanley Fischer, the Fed's current vice chairman, who recently said on CNBC that "we are going to be changing monetary policy from the most extremely expansionary we've been able to do in all of history to an extremely expansionary monetary policy."
Stanley Fischer is arguably the most distinguished monetary economist in the world. But in this case he has things exactly backward. The Fed's monetary policy since 2008 has been the most contractionary since the early 1930s. Fischer is 180 degrees off course.

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COMMENTS (9 to date)
ThomasH writes:

I think too much of your effort goes into the definitional issue of "tight" and "loose" policy as opposed to whether the policy is right or wrong. I don't care if the Fed thinks it has "expansionary" policy as long as it realizes that it is has no been and is not "expansionary" enough to keep NGDP or even the price level on its pre-2008 path.

It's sort of like fiscal policy, which we might call "austerity" because it is not (I think) investing in all the projects with positive NPV's when discounted at the real long term borrowing rate. I'd prefer, however, just to say it's mistaken not to follow that rule rather than argue about whether the word "austerity" ought to apply.

marcus nunes writes:

"Stanley Fischer is arguably the most distinguished monetary economist in the world".
Maybe in another age. Not any longer:
https://thefaintofheart.wordpress.com/2015/06/02/pearls-of-unsound-wisdom/

Scott Sumner writes:

Thomas, I agree that it should not matter whether we refer to money as 'easy' or 'tight'. Unfortunately we live in a world where it does matter. I'm trying to change that.

Scott Freelander writes:

Scott,

I think you may have been right when you wrote that many of us backed the wrong horse when favoring Yellin for Fed chair. Perhaps Summers would've been better, given he favors NGDP targeting and that he's not shown he's afraid to be bold.

On the other hand, his lack of diplomacy has been disastrous at times, as I recall his presidency at Harvard.

Dr. Sumner,

If I understand your position correctly, the "tightness" of monetary policy cannot be accurately measured by either interest rate, the size of monetary stock, or the rate of inflation. Rather the appropriate measure of how tight monetary policy is based on the growth of Nominal Gross Domestic Product (NGDP). If NGDP is growing slower than some critical value monetary policy is too tight irrespective of interest rates or the size of the supply of the money stock and if NGDP is growing too fast then monetary policy is too lose irrespective of interest rates or the size of the monetary stock.

This seems to assume that when the economy is not growing sufficiently fast, there is a demand for credit which is being unmet and it is monetary policy that is preventing the existing credit from satisfying the existing demand. Conversely, if the economy is growing too fast, monetary policy is forcing credit upon the economy faster than the demand can appropriately use it. By setting monetary policy at some sweet spot, credit exactly meets demand and growth continues without excess inflation.

If this is so, would that then end the business cycle?

Benjamin Cole writes:

The anorexic said, "I am eating more than ever. I am eating so much it's the most expansionary diet I have ever had. I will only
lose two pounds this year.".

Barry "The Economy" Soetoro writes:

[Comment removed for irrelevance. Email the webmaster@econlib.org to request restoring your comment privileges. A valid email address is required to post comments on EconLog and EconTalk.--Econlib Ed.]

Scott Sumner writes:

Scott, Yes, but keep in mind that we don't change policy by appointing the right people to the Fed, we change policy by changing the way economists think about monetary policy.

David, You said:

"This seems to assume that when the economy is not growing sufficiently fast, there is a demand for credit which is being unmet and it is monetary policy that is preventing the existing credit from satisfying the existing demand."

No, monetary policy has nothing to do with credit in my view. It's about keeping NGDP growing at a stable rate to avoid unnecessary labor market and financial market shocks.

You also need to be more specific in your wording. When you say "the economy" it's not clear whether you are referring to RGDP or NGDP, two radically different concepts.

NGDP targeting would not end the business cycle, but it would moderate it.

Ben, Good analogy.

Philo writes:

"[The Fed's] job is not to adjust its forecasts up or down, but rather adjust its policy so that its longer-term forecast never needs to be revised." This is a nice, simple statement of the "Target the Forecast" principle. Too bad the Fed, the economics profession, and pundits and journalists covering the economy do not embrace it or even consider it. Is it so hard to grasp? You must be disappointed that your own efforts to promote it have not been more successful.

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