Wall Street analysts often pour over Fed statements looking for clues. A single word may be seen as having vast implications for the future path of policy. After Wednesday’s Federal Open Market Committee meeting, there was a great deal of attention paid to the fact that the Fed dropped the term ‘accommodative’ from the description of its policy stance.
I would argue that rather than becoming less accommodative, Fed policy is actually becoming much more accommodative than in previous years. To see why we first need to consider what economists mean by “accommodative”.
In the media, the stance of monetary policy is usually described in reference to the level of interest rates. A policy of raising rates is viewed as making monetary policy more restrictive, or “tighter.” Conversely, lower interest rates are seen as making policy more accommodative, or “easier.”
But that’s not how economists describe policy. To see why, consider the most expansionary monetary policy of all, a rapid increase in the money supply that leads to hyperinflation. In that case, monetary policy is certainly not restrictive, even though interest rates will generally rise to very high levels during hyperinflation. On the other hand, a reduction in the money supply that leads to deflation will often push interest rates close to zero (as in the 1930s), and yet policy is not accommodative. So interest rates alone do not determine whether money is easy or tight.
Many economists believe that the stance of monetary policy is best described by the level of market interest rates relative to the natural rate of interest, sometimes called the equilibrium interest rate. The natural rate of interest is the rate that would lead to a stable macroeconomic environment. For instance, if the central bank is targeting inflation at two percent, then the natural rate of interest is the rate that produces two percent inflation.
When the Fed sets interest rates above the natural rate, policy is said to be restrictive, or tight. In that case, inflation will fall below the two percent target. When interest rates are set below the natural rate of interest, then inflation will rise above target. Importantly, we cannot directly observe the natural rate of interest; rather we infer whether interest rates are too high or too low by looking at where inflation is relative to the target path.
During the long recovery from the Great Recession, inflation generally ran below the Fed’s two percent target, indicating that monetary policy was excessively restrictive. During the past year, inflation has finally moved above the two percent target, indicating that monetary policy is becoming more accommodative. This occurred because as the economy strengthened, the natural rate of interest actually rose faster than the Fed’s policy target. The Fed fell increasingly “behind the curve.”
Some might argue that Fed policy is more complicated than simply achieving a two percent inflation rate; they have a “dual mandate” that includes high employment. This is true, but adding employment to the mix only reinforces the point that monetary policy is becoming more accommodative. During the recovery of 2009-16, employment was somewhat depressed relative to most estimates of a healthy labor market. More recently, the unemployment rate has fallen below four percent, and the labor market is now viewed as being quite strong.
Thus whether you judge policy solely by considering inflation, or both inflation and employment, you reach the same conclusion. Policy was too restrictive to hit both the Fed’s inflation target and its employment target during 2009-16, and policy is now relatively accommodative, with inflation above the two percent target and the unemployment rate below the 4.0 percent to 4.6 percent range that the Fed views as “full employment”.
The fact that monetary policy is increasingly accommodative does not necessarily imply it is too accommodative. The Fed needs to look beyond the current data and forecast the impact of its policy on the future condition of the economy. Inflation has recently been pushed up by a sharp rise in oil prices, and it’s possible that it may fall back below two percent during 2019. Even so, the balance of risks has recently shifted, and the long period of excessively restrictive monetary policy is over.
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