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Some counterintuitive thoughts on monetary policy

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Some counterintuitive thoughts on monetary policy

Here are five observations about recent trends in monetary policy:

1. The Fed really wants to avoid a further rate hike. This psychological aversion to rate increases is not rational and actually makes it more likely that the Fed will find it necessary to raise rates even further. That’s because this kind of “reversal aversion” is itself a form of forward guidance, which makes monetary policy more clumsy. It increases the risk that disinflation will change course, requiring further interest 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 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 reappoint him as Fed chairman. I don’t know if these accusations of political favoritism are true (I’m skeptical), but if they are, it implies that Powell greatly helped Trump and hurt Biden, even though he seemed to be trying to do the opposite.

The message here is clear. People worry a lot about political bias. But when it comes to monetary policy, policy errors are a much bigger problem than policy bias.

3. has a new essay in Bloomberg:

Rather than maintaining a policy response function anchored in an excessive reliance on backward-looking data, the Fed would do well to take this opportunity to make a belated move to a more strategic view of the 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 not to overreact to the latest inflation numbers.

As I described in a column Last month, this path would not entail an explicit and immediate change in the inflation target, given how much the Fed has exceeded it over the past three years. Instead, it would be slow progress. Specifically, the Fed would “first revise expectations about the timing of the trip upwards to 2% and then, some time later, move to an inflation target based on a range of, for example, 2-3%.” . . .

Although not without risks, such a policy approach would result in a better overall outcome for the economy and financial stability than an approach where the Fed pursues excessively tight monetary policy.

I agree that this would lead to better results for the economy in the coming years. But I don’t think it’s a good idea. Ideally, the Fed would move to a NGDP target of 4%. But if they insist on sticking to the inflation target, they should stay at 2%. This is a classic example of the time inconsistency problem. The best policy for the coming years is not always the best long-term strategy. In the long term, there are enormous gains to be made by creating clear rules and sticking to them.

4. Brad Setser expresses some widely held views on Chinese exchange rate policy:

China must look for policies that bring the country closer to internal and external balance – and that (uncomfortably) means limiting the use of traditional monetary policy instruments.

But it is also reasonable that China has made real efforts to use its domestic policy space to support its own recovery –and so far it has been unwilling to provide direct support to lower-income householdsor to consider reforms to its exceptionally regressive tax system. Logan Wright and Daniel Rosen foot stomped these points in a recent article at Foreign Affairs.

Ultimately, of course, China determines 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 trading partners should encourage China to move toward greater flexibility now, when this would only help China export more of its own products to a reluctant world. Pragmatism must rule.

I have the exact opposite view. China should avoid fiscal stimulus and instead rely on monetary stimulus, even if it leads to a currency depreciation. I also doubt that this kind of yuan devaluation would result in a larger Chinese trade surplus. Monetary stimulus would likely boost Chinese investment, generally reducing the current account surplus. It could also boost domestic savings, but probably to a lesser extent. In other words, the substitution effect resulting from a weaker yen is likely to be weaker than the income effect resulting from money driving GDP growth.

5. John Authers op Bloomberg has an interesting chart showing the contribution of 4 key sectors to overall (12-month) CPI inflation:

Food, energy and core goods are much more affected by “supply shocks” than services. But monetary policy even affects the prices of these goods. So you can think that the red area (services) reflects almost entirely monetary policy, and that fluctuations in the black, blue and gray areas reflect a mix of monetary (demand side) and supply side factors.

Service sector inflation has not improved after October 2023, which is a worrying trend.