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Interest rate cuts may not be enough

Summary:
The Fed should certainly cut their target interest rate. But if the coronavirus problem continues to get worse, that may not be enough to keep monetary policy on tract. A much more effective policy would be to commit to average inflation targeting of 2%/year over the next 5 years. The Fed should indicate that if the coronavirus causes near-term inflation to fall below their 2% target (which is likely), then they’ll go all out to obtain higher inflation in future years, so that 5 years from today the inflation rate will have averaged about 2%. The goal is to raise the equilibrium interest rate on 5-year Treasuries. Doing so will make monetary policy more expansionary today, for any given setting of the policy rate. Another advantage of this approach is that the

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The Fed should certainly cut their target interest rate. But if the coronavirus problem continues to get worse, that may not be enough to keep monetary policy on tract.

A much more effective policy would be to commit to average inflation targeting of 2%/year over the next 5 years. The Fed should indicate that if the coronavirus causes near-term inflation to fall below their 2% target (which is likely), then they’ll go all out to obtain higher inflation in future years, so that 5 years from today the inflation rate will have averaged about 2%.

The goal is to raise the equilibrium interest rate on 5-year Treasuries. Doing so will make monetary policy more expansionary today, for any given setting of the policy rate.

Another advantage of this approach is that the Fed won’t have to backtrack if the coronavirus quickly fades. In contrast, a big cut in interest rates might have to be quickly reversed. There’s actually nothing wrong with quickly reversing an interest rate move as new facts come in, but pundits think it’s embarrassing and hence the Fed is reluctant to “reverse course”. (Of course they aren’t actually reversing course when they cut and then raise rates, as interest rates are not monetary policy.)

PS. Over at Econlog, Steve Fritzinger had a good comment:

My driving policy is to stay 2 to 2.5 seconds behind the car a front of me at all times. To do that speed up and slow down as needed to stay in that window.

If I’m accelerating and decelerating, it doesn’t mean I’ve changed my policy.  It means I’m implementing it.

Here’s another example. My driving policy is to maintain a speed of 65mph. Moving the accelerator pedal as I go up and down hill doesn’t mean I’m changing my policy.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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