CNBC’s Alex Rosenberg interviewed me on the phone last week about how the Fed should approach its moves beyond the first interest rate hike. In advance of our conversation, I pointed him to my tweet saying
Fed should not raise rates until it explicitly commits to reverse course quickly if needed.
and my post Larry Summers: The Fed Looks Set to Make a Dangerous Mistake by Raising Rates this Year where I wrote:
In addition to Larry Summers’ arguments for holding off on raising rates, I have a conceptually quite distinct argument: the Fed can afford to wait to raise rates, because it can always raise rates very fast if it needs to later on.
Contrary to what optimal control models suggest, monetary policy committees around the world tend to believe the fallacy that (although events can sometimes overrule this) it is a good thing to raise and lower rates slowly. This belief shows up as policy rate movements being predictably in one direction for a long time, with small steps along the way. Optimal control models suggest that instead a policy rate should look a lot more like a random walk modified by some drift and mean reversion. That means that optimal monetary policy should have lots of reversals and dramatic movements in the interest rate when there has been relatively big news since the last meeting.
Let me address one myth: that Mike Woodford has shown that interest-rate smoothing makes sense. I would be glad to be corrected, but I think this myth arises because Mike talked about the Fed carrying about affecting the bond markets (and more generally macroeconomic) expectations of future rates. Just as backward-looking state variables have forward-looking costate variables, bond market expectations are like a forward-looking state variable for the Fed; those bond market expectations have a corresponding backward-looking costate variable.
As an analogy, in working toward my dissertation, I did an unpublished efficiency-wage model (which you can see and freely download here) in which, to motivate workers with an expectation of future pay making a job valuable, there is a backward-looking costate variable that can be interpreted as “seniority.”
Such backward-looking costate variables giving guidance about doing the right thing in relation to bond-market expectations contribute additional drift terms to the optimal policy rate, but it still seems to me that over a six-week span of time between FOMC meetings, the variance of news is sufficient that the effect of news should typically be substantially larger than the sum of all drift terms on the policy rate. Hence the metaphor of a muddy random walk.
In our conversation, I emphasized that the responsiveness of the Fed’s interest rate target to news–“data dependence”–should go in both directions. I can easily imagine both events that would indicate the target rate should be raised fast, and events that would indicate that the target rate should be cut significantly–whatever direction the Fed had gone at the last meeting. (As an example of why the Fed might need to cut rates, I pointed to the possibility that a big cut in the European Central Bank’s target rate–which would be the right thing for the European Central Bank to do–might cause a significant appreciation in the US dollar, reducing the contribution of net exports to US aggregate demand.)
I explicitly criticized the inhibition by many central banks against reversing direction, even if incoming data calls for doing so. I also suggested that, overall, being willing to make larger, faster moves in the target rate would make it possible to close output gaps quicker–whether the output gap is negative or positive.
I recommend that you read the whole article for context, but here is how Alex boiled down our conversation (I corrected the spelling of the adjective “dependent”):
For University of Michigan economist Miles Kimball, the fact that hawks and doves have become divided on the question of data dependency — with the former swearing their allegiance to the data, and the latter emphasizing the psychology of market participants — is unfortunate.
“You do want to be data-dependent, but you want to be data-dependent in both directions,” Kimball said in a Friday interview with CNBC. “No one is mentioning the possibility that if the economy ends up doing worse, that the Fed can reverse course.”
In other words, the Fed has the flexibility to cut rates after it has raised them (or in a reverse situation, raise after it has cut them). That would be in stark contrast to the “path” model currently in force, under which the first rate hike begins a one-way path to further hikes, with the only real question being the pace of such hikes.
“The nature of news is that news is bad about as often as it is good. If you’re really and truly data-dependent, it shouldn’t be a shocking thing if you make your target rate go up by a quarter point and then at the next meeting, if bad news comes, cut it back down,” Kimball said. “We’d have better policy if we made interest rates more sensitive to data.”
It looks as if Alex talked to Robert Murphy after he talked to me. Robert said
… there is a view that it’s not the movement in the rate today that really matters; it’s the long-term path for where we see rates going.
Here it is quite important to point out that models that have only nondurables give the misleading impression that only medium-to-long-term rates matters for aggregate demand. Once investment goods and consumer durables are brought in, the short-term interest rate has a separate effect. The reason is that an optimizing decision to buy a durable or investment good must pass two tests:
- The net present value test, which depends on an interest rate over the life of the durable or investment good.
- The Dale Jorgenson delay condition test–“Would it be better to wait to buy the durable or investment good later?”–which depends on the short-term interest rate. (I discuss the importance of this condition in “The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate” and “On the Great Recession.”
Because of the delay condition, the current level of the short-term rate is more important than economists whose intuition has been formed by models of optimal monetary policy with only nondurable consumption might realize.