Wednesday, June 16, 2010
I've been intrigued by this chart for a long time. What I think it shows is that the Fed has typically been very responsive to the state of the economy's health. The capacity utilization rate, shown in the blue line, is a pretty good proxy for how strong or weak the economy is. The real Fed funds rate (using the core PCE deflator) is a good proxy, in my view, for how easy or tight Fed policy is. In the view of those like the Fed that believe in the Phillips Curve theory of inflation, capacity utilization is also a decent proxy for the amount of "resource slack" in the economy, and thus an important input to monetary policy decisions. The logic goes like this: the lower the rate of cap utilization, the more idle resources there are, and the more idle resources, the greater the deflationary pressures on prices, so the more the Fed ought to ease. With cap utilization rates now rising rather rapidly, it would follow that monetary policy ought to begin to tighten.
The Fed doesn't always follow this model, however, as well as it probably should. As this chart shows, there are times when the Fed is proactive (tightening in advance of increases in capacity utilization with the aim of slowing the economy and thus preventing inflation from rising), and there are times when the Fed is reactive (responding with a significant delay to changes in capacity utilization). These different policy responses generally lead to inflation consequences. For example, the Fed was reactive throughout most of the 1970s, and inflation rose substantially. The Fed was proactive from the early 1980s through 1987, and that was a period of significant disinflation (falling inflation). The Fed was then reactive from the early 1990s through 1998, but inflation was relatively low and stable during that period, perhaps because the Fed had been so tight for so long in the decade prior. Since the early 2000s the Fed has generally been reactive, tightening policy with a significant delay in the wake of the strong economic pickup that started in mid-2003. Not surprisingly, inflation accelerated from 2003 through 2008.
The past year or two stand out as unusual in two respects: 1) the economy weakened sharply and to an unprecedented degree, but 2) the Fed took only limited action to ease. The latter can be explained away by noting that although the Fed could not deliver the negative interest rates, as their model (akin to the Taylor Rule) would have called for, it did engage in massive quantitative easing by expanding bank reserves by more than $1 trillion. In any event, we observe that for the past 18 months or so, inflation has been generally tame—does that not mean the Fed has done exactly the right thing?
I'm not ready to say that I have more respect for the Fed or their model of inflation, but I also don't want to ignore the facts. Of course, even the best model can have problems if political considerations overrule the model's policy prescriptions. In any event, going forward this model is saying that the Fed should begin raising rates sooner rather than later, otherwise it will end up committing the sin of reactivity that plagued monetary policy in the 1970s. It's something to think about.
Posted by Scott Grannis at 3:52 PM