Allow Interest Rates To Rise While Keeping Monetary Policy Accommodative
The minutes of the December 11-12 FOMC meeting, released today, have emboldened me to come out of the closet with a monetary policy suggestion and the reasoning behind it that I’ve been reluctant to express before lest I be ridiculed as hopelessly naïve. My suggestion is that the FOMC allow interest rates to rise a bit without easing monetary policy.
I was raised a Milton Friedman monetarist who viewed changes in the money supply as the essence of monetary policy even though such changes were normally associated with pressures on interest rates. Speeding up money growth along with the accompanying downward pressure on interest rates would tend to stimulate a depressed economy. For practical purposes, it wasn’t necessary to determine precisely how much of the stimulus came from money supply growth and how much came from lower interest rates.
The FOMC’s easing throughout 2008 finally brought its policy interest rate, the Federal Funds rate, and related short-term rates, close to zero. At that point—the zero bound point—strict Keynesians focusing only on interest rates declared the Fed out of ammunition to stimulate economic activity further. Monetarists and other non-Keynesians believed that further expansion of money and related credit aggregates would stimulate the economy further even if interest rates were stuck in a liquidity trap. The attempt to stimulate the economy further through open market purchases was called quantitative easing to distinguish it from interest-rate easing. Of course, as the FOMC modified its open market operations into longer maturities and different asset classes, the term “quantitative easing” lost its purity as various other interest rates were targeted along with the size of the balance sheet or the quantity of money and credit aggregates.
Now, getting to my point, I’ve never believed that a given interest rate target required a precise quantity of open market purchases or sales. As long as the open market operations are broadly consistent within a wide range, it is the Fed’s announced intention regarding the Federal Funds rate that signaled the market to make it a reality. In other words, if the FOMC announces that it wants the Federal Funds rate to be 4 percent rather than the existing 5 percent, the amount of open market purchases needed to achieve this target is likely a range rather than a point estimate. And, given Fed credibility, that range might not be so narrow. This leads me to believe that it may be possible to separate, to some extent, the Fed’s interest rate target and its quantity targets.
The recovery in the economy since mid-2009 has been slow and fragile and, in my opinion, in need of the support the Fed has given it. Hence, for a while longer—hopefully not too long—the Fed should keep its balance sheet growing slowly so as to support growth in the money supply. I think that may be possible, while at the same time announcing that it will support interest rates slightly higher than current rates, for the Fed to avoid “tightening” monetary policy in a significant sense. In other words, keep overall policy accommodative through open market operations while signaling a willingness to see somewhat higher interest rates.
Short-term interest rates have been near zero since the end of 2008, and longer-term rates have been depressed as well. We’ve had four years of financial repression as savers struggle to find a meaningful return on their savings. An easy money policy always hurts savers while trying to help investors. For a short-while one might ignore the down side for the greater good, but four years, going on five, is too long. The damage to savers needs to be considered along with the potential further benefits to spenders.
As I indicated earlier, I was prompted to propose such heresy—allow interest rates to rise while keeping monetary policy accommodative—by the minutes of the latest FOMC meeting. According to those minutes, several FOMC members thought the new round of asset purchases and balance sheet expansion might be ended by the end or even before the end of 2013 while interest rates would presumably remain on the floor much longer. Therefore, the Committee has implicitly separated interest rate policy from open market operations, as I am proposing. Unfortunately, they foresee doing the opposite of what I’m suggesting—stopping open market purchases before letting up on interest rates. Maybe further reflection might lead them to consider doing it the other way—easing up on interest rates while continuing open market support.