The Problem With Interest-Rate Policy

Or . . . the problem with interest rates as the primary policy tool.

Interest rates are very blunt instrument. What's more the Fed only has control over a small portion of the entire yield curve. So because it wants to affect the entire yield curve through its policy, it has to act even more dramatically with its otherwise naturally blunt policy instrument.

The Austrians are right when they criticize the use of interest-rate policy as a distorting act of price fixing. Interest is the price of credit. Distortions to the interest-rate curves by the fixing of some prices along it affects the economy. And since the Fed has to act more dramatically since it has limited abilities to control the prices in this market, it has to hit harder with its big, blunt, interest-policy hammer. Right away that should strike us as problematic. We should be very concerned with the way this fractured fairy tale is playing out if this is in fact an accurate depiction, which I believe it is.

At the end of the day interest-rate policy is just a stand-in for communication. Communication is the real key policy for the Fed. The intentions that the Fed has for the money supply is the essential guideline for how that part of the economy is going to change in the future. But once we are down a particular road with monetary policy, a road the Fed may not be completely aware of much less have fully intended, we can't just hop in the Way-Back Machine to go correct matters.

This is the key advantage of using NGDP level targeting, NGPD futures price targeting, or wage growth targeting as the key policy tool. As long as the Fed can make a credible commitment by policy or by law to keeping NGDP towards a clearly communicated growth trajectory, then the economy will be on course to fulfill its potential. We need to lose the illusion that the council of elders with its fearless leader has some grand omniscience granting it the ability to figure out what monetary policy needs to be to keep NGDP on target. In truth the best the Fed can do is set the right long-term target for growth. It is the market that will best to decide what policy is necessary and what changes to policy are necessary to keep the economy on that path.

The economy is a massive ship at sea headed towards a port that lies perpetually over the horizon. The Fed is at the steering wheel, but it is not a navigator. The market is the great navigator. The market has the ability to help the Fed steer in the right direction making the needed corrections along the way and with much more rapid feedback than the long and variable lags our heroes are currently subject to.

In this universe all the Fed has to do is set the target for what level of growth it wants in the economy and then commit by law to pursuing whatever actions it takes to keep the economy at that growth rate. A highly credible Fed would not need to move interest rates and would not need to make significant asset purchases or sales to convince the market that it was truly going to pursue the proper policy to reach its target. A less credible Fed would have to make relatively larger asset purchases or sales as needed and move interest rates as needed to convince the market that it truly was going to follow policies as dictated by the market to reach the policy goal. But credibility has its own momentum, and as it grows it compounds. This is good in that it takes less to keep credibility. This is bad in that a loss of high credibility can portend dramatic repercussions. That is why central bank policy tends to be formalized in law and central bankers tend to be called to account.

Changing the policy tool and the method by which it is derived to a growth-oriented, market-driven focus isn't a magic bullet, but it is a massive step towards a much more sensible world.