What happens when the Federal Reserve makes a mistake? The answer, unfortunately, is “not nearly enough,” thanks partly to an antiquated approach in need of modernization.
In December 2015, the Fed raised its interest rate target for the first time in more than a decade. At the time, Fed officials signaled another four rate increases for 2016 in order to prevent the economy from overheating. Unfortunately, the economy quickly slowed, and the Fed would not raise rates again until the following December. Indeed by early 2016, it was clear that the previous rate increase should not have occurred.
So why didn’t officials immediately admit their mistake and cut rates back to zero in early 2016? It turns out that the Federal Open Market Committee (FOMC) has been exceedingly reluctant to quickly reverse course after setting out on a new policy track.
This is very different from how asset markets work. If stocks fall on Tuesday due to worries about a trade war, the market is not at all reluctant to shoot right back up again on Wednesday, if new information makes that scenario less likely. Unlike Fed policymakers, markets don’t have egos and they don’t worry about “credibility.”
The Fed’s premature tightening of monetary policy in late 2015 ended up slowing the economic recovery, and may well have cost the Democrats the election in the fall of 2016. The 12-month rate of real GDP growth fell to 1.23 percent in the second quarter of 2016, from a peak of 3.76 percent in the first quarter of 2015. Inflation remained below target, while the labor market recovered more slowly than necessary.
We need a system that makes monetary policy more efficient and more reflective of the current state of the economy.
Given modern technology, there is no reason why the Fed can’t adjust its settings far more frequently. FOMC members could, for example, email their preferred interest rate target to Chairman Powell each business day, and the actual Fed target could be set at the median vote.
Instead of quarter-point increments, FOMC members could select an interest rate target to the nearest “basis point”—which is 1/100th of 1 percent. Daily movements would look more like a financial asset price, moving up and down each day in a sort of “random walk” as new information about the economy comes in.
If that regime had been in place in early 2016, the Fed could have reversed its previous rate increase without suffering any embarrassment once it become clear that monetary policy had been set too tight. The job market would have healed at a faster rate, and inflation would have returned to the 2 percent target more quickly.
Unfortunately, we are moving in the wrong direction. Our current regime is what you’d expect of a primitive economy where regional Fed presidents still ride stagecoaches to FOMC meetings in Washington.
The Fed has gradually moved from a regime where decisions on policy are made every six weeks to one where only every other meeting is “in play.” The Fed chair has a press conference after alternating meetings, and it’s widely understood that policy changes are unlikely to occur without a press conference. Indeed the past seven rate increases have all occurred at meetings with a press conference, which occur only once every 12 weeks.
Consider the following quotation from the minutes of a November 1937 Fed meeting. In this meeting, Fed officials considered reversing their earlier decision to raise reserve requirements — a decision now blamed for helping to trigger a severe double-dip depression in late 1937, throwing millions out of work:
We all know how it developed. There was a feeling last spring that things were going pretty fast… If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System [Fed] was the cause of the downturn. It makes a bad record and confused thinking. ... I would rather not muddy the record with action that might be misinterpreted.
Here we see a Fed official arguing that a reversal of the previous mistake would be taken as evidence of Fed guilt — especially if it was successful!
The Fed error of late 2015 was much less consequential, and in fairness they did refrain from the next three anticipated rate increases. But why not aim higher? Given the importance of monetary policy, why not adopt a procedure that best mimics the efficiency of asset markets, which respond immediately and unashamedly to new information about the economy?
Scott Sumner is an emeritus professor of economics at Bentley University, director of the Program on Monetary Policy at the Mercatus Center at George Mason University, and author of the new Mercatus study “Explaining Quantitative Easing.”