Ryan Avent on the Fed's Plans to Keep Rates Low Even After Recovery is Underway

This is a very interesting post by Ryan Avent about the ways in which the Fed is strengthening its “forward guidance”: promises (or at least half-promises) about the Fed’s future actions. Forward guidance has now moved toward clearer plans to keep stimulating the economy even after it has already recovered.

I have written elsewhere that I have misgivings about forward guidance. (Here is the thread of all my monetary policy posts, and here is the last previous post that addressed this issue.)  I had an extended email discussion with an economist in the Federal Reserve System (whom I will not name) who argued passionately that, given our lack of knowledge about what will work and what won’t, the Fed should be using both large-scale asset purchases and promises that it will keep stimulating the economy even after it has reached the natural level of output–planning to push the economy above the natural level of output for a while.

I still would rather the Fed increased the scale of its asset purchases than strengthen its promises to push the economy beyond the natural level of output in the future. And I am especially uncomfortable with expressing this commitment in terms of specific dates. If the Fed thinks it must commit to going above the natural level of output for a while, it would be better for the Fed to commit to get the aggregate price level back to a track of prices that has increased on average by 2% per year since 2008. (That would be price-level targeting, which is consistent with NGDP targeting as long as the natural level of output is growing at a constant rate.) That would clearly limit how much overstimulation the Fed was indicating it would do–just enough to have enough inflation in excess of 2% to balance out the cumulative inflation we have had below 2% in the last few years. I also believe that if the Fed had done sufficient asset purchases in the last few years (for example, if QE1 and QE2 had each been three times as large), the economy would have recovered enough that the Fed would never have been tempted to rely as heavily on “forward guidance” as it now is. Those who think that large scale asset purchases have large costs aside from the level of stimulus they provide to the economy–which for the sake of this argument I am taking to be a benefit–should articulate clearly what they think those costs are.

The costs of the Fed tying its hands in this way will become evident in the future. I have a memory (perhaps faulty) that having given earlier forward guidance that interest rates would stay low may played some role in the low interest rates the Fed maintained in 2003–low rates that have been blamed, perhaps very unfairly, for helping to create a housing price bubble. I would be glad to hear more about the extent to which readers think earlier forward guidance played a role in the Fed’s maintenance of low interest rates in 2003.