Get Ready for Interest Rate Shocks

One of the important messages coming out of the central banker’s annual retreat in Jackson Hole, Wyoming is that once the crisis is over the Federal Reserve’s (Fed) tightening of monetary policy may be abrupt. If so, increases in short term interest rates will not be gradual but jarring. The reasoning behind this approach, as I understand it, is that (1) since there could be political pressures to monetize the government debt and (2) given the large amount of existing liquidity that needs to be drained the Fed’s exit strategy needs to be unmistakably clear in communicating that it will not tolerate the unanchoring of inflationary expectations. Here is the New York Times:

A growing number of economists and some Fed officials say the shift to tighter monetary policies and higher interest rates, though unlikely to start until at least the middle of next year, may have to be much more abrupt than normal if they are to prevent inflation two or three years from now.

“When you get into a crisis like this, gradualism is not the right strategy,” said Frederic S. Mishkin, an economist at Columbia University who was a Fed governor from 2006 until 2008. “Of course, when things turn around, you have to be aggressive in the other direction.”

And here is the Wall Street Journal on the talk Carl Walsh gave at the retreat:

[O]nce the Fed does start raising the federal-funds rate out of its current record-low range near zero, “it should be increased quickly,” Mr. Walsh argued. “There is no support for raising rates at a gradual pace once the zero rate policy is ended.”

This rhetoric is sounding so Paul Volker-like. It remains to be seen, though, whether the Fed could actually make such abrupt changes in monetary policy. There are two major obstacles to such an approach. First, now that the global economy has become addicted to a low interest rate policy, any drastic tightening will amount to a painful interest rate shock. Second, tightening policy may make the budget deficits even larger and make it more costly to finance, a point alluded to in the New York Times article:

Indeed, the Federal Reserve’s “exit strategy” could lead to a clash with the Obama administration. The White House plans to release its newest budget estimates next week, and administration officials said that the 10-year deficit will rise to $9 trillion — a big jump from its earlier estimate of $7 trillion.

In the future, Fed officials could feel more pressure to further tighten monetary policy as a way of countering the government’s deficit spending. The immense amount of borrowing could push up long-term interest rates, if foreign investors balk at buying up United States debt.

Of course, all of this analysis assumes the Fed knows when the time is right to begin its exit strategy. As noted in my previous post, however, even this assumption is questionable. Fed policy over the next few years should be a doozy to watch.

About David Beckworth 240 Articles

Affiliation: Texas State University

David Beckworth is an assistant professor of economics at Texas State University in San Marcos, Texas.

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