As the Fed Moves, It Needs a Road Map
A clear strategy should include how monetary policy ideally would fit with fiscal policy.
Now that the Federal Reserve has raised its target federal-funds rate, its next and more important task is to establish how monetary policy should be conducted and clearly communicate its decisions to the public.
The rules-versus-discretion debate, teed up by legislation recently proposed in the House of Representatives, is useful. But it is not the only, or even the best, framework for discussions about monetary policy. Instead, the Fed needs a road map—a clearly defined objective and a strategy for achieving it. This would include the monetary policy mix it will follow and how that mix ideally would fit with fiscal policy.
Why a road map? Consider: A rigid rule about how to get from New York to Los Angeles won’t work all the time. But a vague statement about “heading west” provides too little guidance, and too much discretion. Explaining why a travel route might change is more important than describing the trip as “data-dependent.”
By statute, the Fed’s objectives are maximum employment, stable prices, and moderate long-term interest rates. But how does the Fed attempt to meet these often competing objectives? What weight does it give to one over the other? The Fed can certainly make adjustments along the way—much like a GPS device does when necessary—but it’s destination should be clear and clearly articulated.
Gradual increases in interest rates will not harm business investment, and the Fed’s worries about this seem overblown. The cost of capital is already very low, and corporate balance sheets are in excellent shape for funding desired investment.
Fed rate increases in an improving economy have not slowed the recovery since the early 1980s. When it failed to raise rates in September, the Fed caused markets to become uncertain about its strategy—with negative effects on equity prices and financial conditions. Moreover, rising interest rates will improve household incomes by increasing the returns on the large amount of interest-bearing assets held by households.
Laying out a strategy for further rate increases is the Fed’s critical next step. The pace of its increases in short-term rates will be influenced in part by the Fed’s assessments of financial conditions as long-term rates change. If markets expect higher short-term rates in the future, this typically translates into higher long-term rates today—and a higher cost of capital for business investment and housing. But continued large-scale asset purchases by the European Central Bank and the Bank of Japan could constrain the rise in long-term yields. The Fed might need to increase short rates more rapidly to achieve its objectives for economic activity.
Better communication is a vital part of a Fed road map. Members of the Federal Open Market Committee say they are data-dependent. But individual members seem to have different definitions of what data are relevant—labor-market conditions, financial conditions, Chinese economic growth, geopolitical stability. The range of possibilities are not helpful for markets.
The Fed should explain to the public that interest rates even 100 basis points higher than today are not high—and acknowledge the potential costs to financial stability of abnormally low rates. The Fed has an ongoing problem with too-low consumer inflation; but if commodity prices cease to decline or turn around, core inflation will then rise. If the Fed delays too much in further increases in rates, it will be difficult to explain why it is keeping monetary policy ultra-accommodative in an economy with GDP growing roughly at its potential growth rate and a falling unemployment rate.
After the depths of the financial crisis, the government has depended too much on the Fed to support economic activity. Fiscal policy could have reduced the cost of capital substantially through greater investment incentives and business-tax cuts. Commitment to a long-term program of infrastructure spending could have reset expectations of future demand.
Economic growth is vital, but it can’t be achieved through monetary policy, certainly not by monetary policy alone. Fundamental tax reform, by contrast, could raise the GDP growth rate by a half-percentage point a year for a decade. Reducing marginal tax rates on work—in the income tax, the Affordable Care Act, and the phase-out of the Earned Income Tax Credit, would also help arrest and turn around the decline in labor-force participation about which the Fed is rightly concerned.
The Fed has taken the first step toward a more normal monetary policy. Whether that step becomes a journey requires a road map.
This op-ed appeared in The Wall Street Journal on January 3, 2016.