March 28, 2015
The Washington Post missed the opportunity to correct Stanley Fisher, the vice-chair of the Federal Reserve Board, on his arguments for raising interest rates. An article on the prospect of Fed rate hikes later this year quoted Fisher on the desirability of raising rates so that the Fed would have room to use normal monetary policy (i.e. lower interest rates) if there was a shock to the economy leading to a slowdown. There are two major flaws in this logic.
First, if the Fed delays raising interest rates and allows more job creation and economic growth, we are more likely to see higher inflation. If the inflation rate starts to rise, the Fed could raise the federal funds rate along with it, leaving real interest rates unchanged. If the inflation rate goes to a somewhat higher level, this would provide the Fed with considerably more ability to boost the economy in a downturn with conventional monetary policy since it could have lower real interest rates. (The real interest rate is the nominal interest rate minus the inflation rate.) This would be especially the case if it allowed the inflation rate to rise above its current 2.0 percent target.
In this respect, it is important to remember that the 2.0 percent target is just a number chosen by former chair Ben Bernanke. It is not part of the Fed’s legal mandate to promote high employment and price stability.
The other flaw in Fisher’s logic is that he is effectively advocating that the Fed deliberately slow growth now so that it will have more ability to speed growth later. This is a rather peculiar argument, sort of like committing suicide to ensure that you won’t be killed. Would it make sense to say, slow growth by a total of 1.0 percentage points over the next two years to ensure that the Fed has enough room to lower interest rates and thereby speed growth by 1.0 percentage point in response to a possible future shock? (Fisher undoubtedly would have different numbers.)
It is at least peculiar to argue that we should for certain take a large loss now, in the form of higher unemployment and lower wages for those at the middle and bottom of the wage distribution, in exchange for being better able to respond to a possible loss in the future. Unless the potential gains from the latter action are much larger than the certain losses from raising interest rates, this would be a bad trade-off.
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