Here are five observations about recent trends in monetary policy:
1. The Fed would really like to avoid any further increase in interest rates. This psychological aversion to interest rate increases in not rational, and it actually makes it more likely that the Fed will find it necessary to raise interest rates even further. That’s because this sort of “reversal aversion” is itself a form of forward guidance, which makes monetary policy more clumsy. It increases the risk that disinflation will reverse course, requiring further rate increases.
2. I’ve seen claims that Jay Powell privately prefers Biden to Trump. People often cite the fact that he refused to cut interest rates as often as Trump would have liked, and that he refrained from tightening monetary policy in late 2021 as Biden was considering whether to re-appoint him as Fed chair. I don’t know if these accusations of political favoritism are true (I’m skeptical), but if true it implies that Powell ended up greatly helping Trump and hurting Biden, even while appearing to be trying to do the opposite.
The message here is clear. People worry a great deal about political bias. But when it comes to monetary policy, policy mistakes are a far greater problem than policy bias.
3. Mohamed A. El-Erian has a new essay in Bloomberg:
Rather than maintain a policy reaction function anchored by excessive dependence on backward-looking data, the Fed would be well advised to take this opportunity to undertake a belated pivot to a more strategic view of secular prospects. Such a pivot would recognize that the optimal medium-term inflation level for the US is closer to 3% and, as such, give policymakers the flexibility to not overreact to the latest inflation prints.
As I detailed in a column last month, this path would not involve an explicit and immediate change in the inflation target given the extent to which the Fed has overshot it in the last three years. Instead, it would be a slow progression. Specifically, the Fed “would first push out expectations on the timing of the journey to 2% and then, well down the road, transition to an inflation target based on a range, say 2-3%.” . . .
While not without risks, such a policy approach would result in a better overall outcome for the economy and financial stability than one that sees the Fed run an excessively tight monetary policy.
I agree that this would result in a better outcome for the economy over the next few years. But I don’t believe that it’s a good idea. Ideally, the Fed would shift to a 4% NGDP target. But if they insist on sticking with inflation targeting, they should stay at 2%. This is a classic example of the time inconsistency problem. The best policy for the next few years is not always the best long-term strategy. In the long run, there are huge gains from creating a clear rule and sticking with it.
4. Brad Setser expresses some widely held views regarding China’s exchange rate policy:
China needs to look for policies that move it closer toward book internal and external balance – and that (uncomfortably) means limiting the use of classic monetary policy tools.
But it is also reasonable that China made a real effort to use its domestic policy space to support its own recovery—and so far it has not been willing to provide direct support to lower income households, or to consider reforms to its exceptionally regressive tax system. Logan Wright and Daniel Rosen foot stomped these points in a recent article in Foreign Affairs.
Ultimately, of course, China sets its own exchange rate policy; it has a long history of ignoring external advice that goes against its self-perception of its own interests. But there is no reason why China’s trade partners should encourage China to move toward more flexibility right now, when it would only help China export more of its own manufactures to a reluctant world. Pragmatism should rule.
I have exactly the opposite view. China should avoid fiscal stimulus and instead rely on monetary stimulus, even if this results in currency depreciation. I also doubt that this sort of yuan depreciation would result in a larger Chinese trade surplus. Monetary stimulus would likely boost Chinese investment, which tends to lower its current account surplus. It might also boost domestic saving, but probably by a smaller amount. In other words the substitution effect resulting from a weaker yen is likely to be weaker than the income effect resulting from easy money boosting GDP growth.
5. John Authers at Bloomberg has an interesting graph showing the contribution of 4 key sectors to the overall (12-month) rate of CPI inflation:
Food, energy and core goods are much more strongly affected by “supply shocks” than are services. But monetary policy does impact even the prices of these goods. Thus you can think of the red area (services) as almost entirely reflecting monetary policy, and fluctuations in the black, blue and grey areas as reflecting a mix of monetary (demand side) and supply side factors.
Service sector inflation stopped improving after October 2023, which is a worrisome trend.
