The Fed and the New Monetary Consensus: The Case for Rate Hikes, Part Two

From this paper's Preface, by Dr. Dimitri B. Papadimitriou, President: In Public Policy Brief No. 79, L. Randall Wray wrote about the Federal Reserve’s recent interest rate hikes that "the most charitable interpretation of the Fed’s policy change is that it appears to be premature."Wray marshaled a convincing array of data on payrolls, employment-to-population ratios, and other labor market indicators to show "that the current recovery has not yet attained the degree of labor market tightness that was common in previous recoveries," and therefore that the threat of inflation was minimal. Hence, the Fed, in raising rates, was unnecessarily jeopardizing the economy’s weak recovery. In this new brief, we learn about the flaws in the Fed’s thinking that have led to its frequent policy mistakes.Wray traces several strands of current central bank thinking back to their roots in the Fed’s internal discussions in the mid-1990s. Transcripts of these discussions have recently been released, a development that has yielded some disturbing and telling insights about the way in which monetary policy is formed. The situation of 1994 closely parallels that of current times. Unemployment was clearly above its lowest sustainable level, and inflation was low. Still, the Federal Open Market Committee (FOMC) and its chairman, Alan Greenspan, believed that interest rates had to be raised to keep prices in check. As it turned out, inflation stayed low, even as unemployment sank to levels previously believed to be inflationary. The Fed’s interest rate hikes proved to be unnecessary at best and counterproductive at worst. Not only is the current economic environment reminiscent of 1994, but so are contemporary justifications for recessionary policies.Wray lists six tenets of policy making common to both periods: transparency, gradualism, activism, low inflation as the only official goal, surreptitious targeting of distributional variables, and the neutral rate as the policy instrument to achieve these goals. The Fed would not be eager to espouse some of these principles publicly, but they were all discussed in committee meetings, as the recently released transcripts make clear—and there is no reason to think the Fed has changed its philosophy. Wray shows that this philosophy is convoluted. Fed officials claim that they are attempting to reach a neutral interest rate that neither provokes inflation nor causes recession. But they also say that they will not know the level of the neutral rate until they reach it. Little can be gained by pursuing such a chimerical goal. Moreover, even when the interest rate was far below its supposedly neutral level, the economy seemed to be free of inflation. Finally, the Fed seems to have painted itself into a corner by promising in advance a gradual series of interest rate increases. It is small wonder that the press finds the Fed’s public statements to be somewhat confusing and cryptic. The Fed transcripts shed light on the events of 1994 and those of the present day. I think that it is time for a new approach to monetary policy; this brief shows why.