Sunday, October 25, 2009

The Fed and Policy Uncertainty

How and when should the Fed unwind the enormous monetary expansion it undertook in response to the financial crisis and recession:

As the Federal Reserve's next meeting approaches in early November, an internal debate is brewing about how and when to signal the possibility of interest-rate increases.

The Fed has said since March that it will keep rates very low for an "extended period." Long before it raises rates, however, it will need to change that public signal to financial markets.

Because the recovery is so young and is expected to be so weak, many central bank officials are comfortable, for now, keeping rates very low. But they are beginning to strategize about how to walk away from the "extended period" language.

My suggestion is that the Fed announce a path of gradual increases in the federal funds rate, say beginning next year and lasting for two years, until the rate is at some "normal level."

This approach is different than what the Fed is likely to undertake; it will probably want to maximize "discretion," the ability to adjust on the fly as conditions unfold.

My approach maximizes predictability and reassurance: it commits the Fed to shrinking the money supply and heading off future inflation. This reassures markets and takes substantial uncertainty out of the picture.

The problem with my approach is the pre-commitment: everyone knows the Fed could abandon a pre-announced path.

But such an announcement might still give markets useful guidance, and the Fed would know that any deviation would itself upset markets, and this might encourage adherence to the pre-commitment.

I do not expect the Fed to follow my advice, but I think it is an approach worth considering.

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