My initial reaction to the FOMC decision this week was disappointment. That has not changed, but after reading other observations and thinking about it some more I am now disappointed for other reasons. For the FOMC decision can be interpreted as adding monetary stimulus, but only in a way that creates further uncertainty and problems for the Fed. Let me explain why.
The FOMC’s new declaration that it will likely hold its target interest rate at 0.25 percent until mid-2013 can be viewed as creating new monetary stimulus. As Matt Rognlie notes, the Fed through this policy has changed the expected path of future short-term interest rates to a lower level, one that implies greater monetary stimulus and thus higher economic activity in the future. This future expansion, in turn, makes households and firms more likely to spend today because one, it improves their economic outlook and two, it lowers the real interest they face via higher expected inflation. Alternatively, one can take Justin Wolfer’s view that this new path of low short-term interest rates in conjunction with the term structure of interest rates means lower long-term interest rates than would otherwise prevail. This, then, provides the same outcome of another round of QE, but does so without the controversy surrounding the QE programs.
This approach to monetary stimulus, however, is fraught with uncertainty for several reasons. First, as noted by Bill Woolsey, the lower interest rate path could alternatively be viewed as the Fed simply revising down its forecast through mid-2013 and accordingly adjusting its target interest rate to maintain the current stance of monetary policy, which has not been very stimulative. In other words, the Fed now expects the natural interest rate to remain lower longer than expected and thus now expects to keep its federal funds rate target lower for a longer time too. The more optimistic view of Matt Rognlie assumes that the expected future path of the federal funds rate will not only be lower longer, but that it will also be below its natural rate level and thus be stimulative. Woosley’s point is that this may not be the case. Likewise, in Justin Wolfer’s scenario this reasoning implies a drop in long-term interest rates could be reflecting a drop in the economic outlook rather than the Fed pushing long-term rates below their natural rate level. Since no one knows for sure, this creates more economic uncertainty.
A second reason this policy creates more economic uncertainty is that it was not accompanied by an explicit level nominal target. Thus, even if Rognlie’s and Wolfer’s assessments are correct, one still does not know how long or where the monetary stimulus would lead. All that is known is that the FOMC “currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” What does “likely” mean here? Such vague guidance is the consequence of there being no explicit level nominal target. Had the Fed had announced a price level or nominal GDP level target, then one would have a much clearer road map of how the federal funds rates would be allowed to evolve over time. The destination would be clearly spelled out (e.g. the Fed will maintain low federal funds rate until nominal GDP hits pre-crisis 1984-2007 trend) which would make it easier to do long-term planning. Such certainty would make the monetary stimulus more effective.
The lack of explicit level target also creates another concern with such a policy. In the absence of such a target, which allows aggressive monetary stimulus in the short-run but constrains and anchors the long-run path of nominal variables, an interest rate peg like the one the Fed has announced has the the potential to create another unsustainable boom down the road. Imagine the economy eventually begins to recover and causes the natural rate of interest to increase. Without a clear road map and strong nominal anchor, the Fed may be slow to react and inadvertently keep the federal funds rate too low after the natural rate has increased. This is George Selgin’s concern with the FOMC decision. Although this outcome may seem remote now, it shows that without the guidance of an explicit level nominal target the Fed’s interest rate peg can have problems in both stimulating the economy and in keeping it on a sustainable growth path.
I remain, therefore, disappointed with the FOMC’s decision.