Uncertainty about the trajectory of the Fed's monetary policy has increased in recent days due to the risk of instability in the financial system. This is not the first time that the bank's targets and the state of the markets have posed a dilemma for monetary policy.
It is time for Powell to revisit Brainard's principles and take a closer look at them. As old Blinder reminds us, Powell should take the manual out from under his arm and show respect for these principles.
The text below reproduces part of the book by Alan Blinder, former Vice-Chair of Fed.
Central Banking in Theory and Practice – Alan Blinder (1999)
Policymakers in the United States and elsewhere have often been accused of making a particular type of systematic error in the timing of policy changes. Specifically, it is alleged that they overstay their policy stance—whether it is tightening or loosening—thereby causing overshoots in both directions. I believe this criticism may be correct, although I know of no systematic study that demonstrates it. I furthermore believe that the error, if it exists, may be due to following a strategy I call "looking out the window."
The error is well illustrated by what I call the parable of the thermostat. The following has probably happened to you; it has certainly happened to me.
You arrive at night in an unfamiliar hotel and find the room temperature too cold. So you turn up the heat and take a shower. Emerging 10 minutes later, you still find the room too cold. So you turn the heat up another notch and go to sleep. At about 2 a.m. you wake up in a pool of sweat in a room that is oppressively hot.
By analogy, a central bank following the "looking out the window" strategy proceeds as follows. For concreteness, suppose it is in the process of tightening. At each decision making juncture, the bank takes the economy's temperature and, if it is still too hot, tightens monetary conditions another notch. Given the long lags in monetary policy, you can easily see how such a strategy can keep the central bank tightening for too long.
Now compare "looking out the window" to proper dynamic optimization. Under dynamic programming, at each stage the bank would project an entire path of future monetary policy actions, with associated paths of key economic variables. It would, of course, act only on today's decision.
Then, if things evolved as expected, it would keep following its projected path, which would be likely (given the lags in monetary policy) to tell it to stop tightening while the economy was still "hot." Of course, economies rarely evolve as expected. Surprises are the norm, not the exception, and they would induce the central bank to alter its expected path in obvious ways.
If the economy steamed ahead faster than expected, the bank would tighten more. If the economy slowed down sooner than expected, the bank would tighten less or even reverse its stance.
Do central banks actually behave this way? Yes and no. Like a skilled billiards player who does not understand the laws of physics, a skilled practitioner of monetary policy may follow a dynamic programming-type strategy intuitively and informally. In the last few years, for example, the notion that it is wise to pursue a strategy of "preemptive strikes" against inflation seems to have caught on among central bankers.
The main impetus for this change in fashion was, I believe, the leadership and perceived success of the Federal Reserve in first tightening monetary policy "preemptively" in early 1994 and then achieving the fabled "soft landing." By now, a variety of other central banks are talking the same talk.
But the very fact that this style of decision making was perceived to be a great advance suggests that the dynamic programming way of thinking has not yet permeated central banking circles.
A preemptive strategy implies a certain amount of confidence in both your forecast and your model of how monetary policy affects the economy, both of which are hazardous. But preemption does not require too much confidence. Remember the flexibility principle of dynamic programming and the Brainard conservatism principle¹. Taken together, they lead to the following sort of strategy:
Step 1. Estimate how much you need to tighten or loosen monetary policy to "get it right." Then do less.
Step 2. Watch developments.
Step 3a. If things work out about as expected, increase your tightening or loosening toward where you thought it should be in the first place.
Step 3b. If the economy seems to be evolving differently from what you expected, adjust policy accordingly.
Two final points about preemptive monetary policy are worth making. First, a successful stabilization policy based on preemptive strikes will appear to be misguided and may therefore leave the central bank open to severe criticism.
The reason is simple. If the monetary authority tightens so early that inflation never rises, the preemptive strike is a resounding success, but critics of the central bank will wonder—out loud, no doubt—why the bank decided to tighten when the inflationary dragon was nowhere to be seen.
Similarly, a successful preemptive strike against economic slack will prevent unemployment from rising and leave critics complaining that the authorities were hallucinating about rising unemployment. Precisely these criticisms of the Fed's tightening in 1994-1995 and subsequent easing in 1995-1996 were heard in the United States in recent years.
Second, the logic behind the preemptive strike strategy is symmetric. The same reasoning that tells a central bank to get a head start against inflation says it should also strike preemptively against rising unemployment.
That is why Chairman Alan Greenspan told Congress in February 1995, just after the Fed had completed a year-long tightening cycle that raised short-term interest rates 300 basis points, that: "There may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see signs that underlying forces are acting ultimately to reduce inflationary pressures.".
In fact, the statement itself amounted to a monetary easing, since it fueled a bond-market rally well before the Fed started cutting interest rates (which did not occur until July 1995). Notably, both Greenspan's statement and the Fed's interest-rate cut in July 1995 came while the unemployment rate was below contemporary estimates of the natural rate.
Under what circumstances might the preemptive strike strategy apply more to fighting inflation than to fighting unemployment?
Third, lags in monetary policy could be longer for inflation fighting than for unemployment fighting, calling for earlier preemption in the former case. This last circumstance appears to obtain, and may be the main justification for acting more preemptively against inflation than against unemployment.
Note, however, that political considerations most likely point in the opposite direction. In most situations, the central bank will take far more political heat when it tightens preemptively to avoid higher inflation than when it eases preemptively to avoid higher unemployment.
