Has The Fed’s Monetary Policy Playbook Run Out Of Road?

Whatever your view of the higher inflation expectations of late, particularly if firmer pricing pressure persists, it would be a distinct change from what’s prevailed over the past 40 years. Disinflation/deflation (DD) has been a dominant macro factor since Paul Volcker broke the back of inflation in a run of uber-hawkish monetary policy in the early 1980s. Since then, DD reigns supreme, arguably to the point that the policy of promoting this outcome has become a problem in its own right.

Forty years ago, suppressing inflation and targeting lower interest rates were deemed a public good. But those objectives long ago lost their luster and are now seen as a sign of an economic challenge confronting the central bank.

But aren’t low interest rates and low/falling inflation always and everywhere a productive economic objective? You could convincingly make that case in the 1980s, but the macro landscape has evolved so that lower rates and pricing pressure appear to be reducing the odds of achieving stronger, sustainable economic growth.

Part of the problem is that low interest rates, in contrast with the general perception, are a sign of tight money. Economist Scott Sumner, among others, has been making this point for years:  “Tight money leads to lower NGDP growth and lower interest rates over the sort of time period that matters for the issues that people care about.”

Empirically, it’s easy to demonstrate the relationship. For example, comparing the 10-year Treasury yield with the one-year change in the core Consumer Price Index since the late-1950s reveals a strong positive link: low (high) rates equate with low (high) inflation.

After decades of pursuing lower inflation (and lower interest rates), the critical question has become: Is this game plan broken? If so, what comes next?

Consider the Fed’s target rate. During every recession and recovery since the 1980s a recurring pattern has held: the Fed lowers interest rates, which are subsequently raised once the recovery takes hold. But the rebound in rates always tops out well below the previous high.

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Disclosures: None.

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