Dec 10, 2018

Rate Hike Controversy Shows Why Monetary Policy Should Be Market-Driven

Patrick Horan Program Manager, Andrea O'Sullivan Feature Writer

Few things are as critical to a nation’s economic health as monetary policy. The Federal Reserve’s interest rate decisions can be the difference between stable prosperity and chaotic volatility.

The Fed’s challenge is to set its interest rate target, called the federal funds rate, at just the right point. If it’s too low, the economy runs the risk of high inflation. If it’s too high, the Fed could inadvertently cause a recession.

As it considers its next move, it’s worth thinking about how the Fed can improve its decision-making.

The Fed is now intent on raising rates after a decade of keeping them at near-zero. The Federal Reserve Open Market Committee (FOMC), the Fed body charged with setting monetary policy, has slowly raised the federal funds rate from 1.5 percent to 2.25 percent since March.

Further hikes within the next months are likely. In August, Fed Chair Jerome Powell defended this gradual interest rate “normalization,” citing a strong labor market and rising incomes as support. The Fed has sent similar signals since at least September, so another hike at the FOMC’s final meeting in mid-December seems very possible.

But not everyone is happy with the Fed’s hike talk.

President Trump has publicly criticized the Fed for raising rates, as have many economists, including former Obama Administration’s chief economist Jason Furman.

The Fed’s critics have good reason to be worried about a December increase. Inflation has slowed, oil prices have fallen, and volatility has rocked the stock market over the past months.

When the Fed increases its target interest rate, it puts upward pressure on other interest rates throughout the economy and reduces the money supply. This causes economic activity to contract.

Such an increase makes sense when inflation is high, but a premature rate hike can increase the cost of borrowing and investing so severely that it causes a recession. On the other hand, if the Fed raises its target too slowly, then it risks rising inflation, which harms consumers and savers.

The current controversy over whether the Fed should raise its target illustrates the difficulty of setting monetary policy, especially when different economic variables send different signals about what action is appropriate. It can be very hard to make the right decision in an uncertain world where so many variables need to be taken into account.

There are two major problems with the way that the Fed makes monetary decisions.

The first is the ambiguity of the Fed’s “dual mandate,” which places the central bank in the immensely difficult position of chasing low unemployment and low inflation at the same time. To deal with this conundrum, the Fed has settled on a two percent inflation target as the most consistent way to achieve this goal. But it sometimes deviates from this ideal because inflation and unemployment are not always in sync.

The second is the discretion that the Fed uses to pursue this target. Fed economists consider a number of economic variables when contemplating a rate change. But they lack direct market input in the form of a price signal.

Reforming how the Fed makes decisions would reduce the likelihood of critical monetary errors.

One way to do this is to make Fed policy more market-driven. Instead of relying on FOMC members’ discretion, the Fed should channel wisdom dispersed throughout the economy.

Mercatus Senior Fellow Scott Sumner has one proposal: establish a nominal gross domestic product (GDP) futures market.

Rather than targeting inflation, the Fed would target nominal GDP growth, which is the sum of inflation and real GDP growth. Since unemployment is a large factor in determining real GDP growth, by stabilizing nominal GDP growth, the Fed targets a single variable, which encompasses both inflation and unemployment. Thus, while inflation and unemployment may fluctuate to some degree under a nominal GDP target, in general, both should be kept fairly stable.

In order to achieve a nominal GDP target, Sumner recommends the Fed establish a futures or prediction market. This would allow the Fed to learn what the market expects nominal GDP growth will be the in future and to set monetary policy accordingly.

For example, if the Fed set a nominal GDP growth target of five percent, it would buy and sell nominal GDP futures contracts on the open market until its forecast also reaches five percent. Traders would buy and sell if the Fed was off-course. Therefore, under this proposal, the Fed channels the “wisdom of crowds.”

This is not to say market forecasts are always accurate, but they are more likely to be accurate than any one individual forecast. This is one reason why the stock market is considered to be an indicator of stocks’ perceived future value (indeed, this may be part of the reason why stocks briefly rallied after Chair Powell hinted the Fed may actually slow future rate hikes).

Setting appropriate monetary policy is an immensely difficult job, but the Fed can make its job easier by better integrating market wisdom into its decisions.

Photo credit: Spencer Platt/Getty Images

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