Last December the Fed adopted a so-called “Evans Rule,” which calls for near-zero interest rates (at least) until one of the following two boundaries are hit:
- Core PCE inflation is expected to exceed 2.5% on a sustained basis.
- Unemployment falls below 6.5%
This brought some welcome transparency to the monetary policy process, but falls well short of what’s needed. The basic problem is that the boundaries are in one direction only—markers for when to tighten policy. There are no boundaries provided as to when monetary policy needs to be made more expansionary.
Suppose it took 1000 years for the US to reach either of the 2 boundary conditions. The Fed could still claim that it had adhered to the Evans Rule, yet no one would regard the policy as a success. Indeed something like this was occurring in Japan, until the recent policy change (and it’s unclear as to whether they will hit their 2% inflation target.)
Michael Darda recently sent me data showing that the PCE is up only 1.0% over the past 12 months, and the more important core PCE is up only 1.1%. The obvious solution is to make the Evans rule symmetrical around 2%. Thus if more than 2.5% core PCE inflation triggers tighter money, then less than 1.5% inflation triggers easier money.
Interestingly, this proposal seems more “dovish” than the Evans Rule, and it is, and yet it’s still too hawkish to fit the Fed’s dual mandate, as it’s equivalent to a 2% inflation target with no weight on employment. That’s right, my dovish reform proposal is still too hawkish to be legal. Just one more indication of how far monetary policy has drifted from the golden age of the Great Moderation. But even small blessings would be welcomed.
I could extend this idea to the unemployment boundary, but I’m not really a fan of targeting unemployment. Obviously I’d prefer a 5% NGDP target path, with 4% and 6% boundaries, if the Fed wants to actually adhere to its dual mandate. (In a few years we could gradually reduce that growth rate, if we opt for level targeting.)
We can discuss what additional stimulus would be adopted when inflation falls below 1.5%. It might be lower IOR, but additional QE is more likely. I’ve argued that QE should increase by 20% per month, until we are out of the zero rate bound, or the Fed owns planet Earth, whichever comes first. Whatever the Fed decides, they need to be more aggressive. Although nominal growth has been pretty stable in recent years, despite increasing austerity, it’s also been below the Fed’s forecasts, and below their policy target.
The Fed hopes things will pick up soon. But hope is not a plan.