The importance of overshooting monetary policy

The general concept that monetary policy should react in a strong fashion to try and bring an economy back on track is fairly widespread. In fact, it makes up a big part of how even John Taylor, nowadays on the very hawkish side of things when it comes to monetary policy, thinks central banks should proceed when they feel the need to act. In particular, the Taylor principle states that in order for a central bank to cool an economy it perceives to be overheating, it needs to raise interest rates by more than the expected rise in inflation. If inflation, for instance, deviates from the central bank target rate by 1%, the central bank should raise interest rates by something like 1.5%. Of course this basic prescription follows the idea that the real interest rate equals the nominal interest rate minus (expected) inflation. If you want to reduce economic activity by raising real rates, you clearly have to raise nominal rates by more than expected inflation. But the importance of this basic notion goes far beyond this almost trivial explanation, and more so in the case of current policy. Kugman’s concept of “credibly promising to be irresponsible” (.pdf) is also aimed in this direction. Overshooting, or “doing more than strictly necessary”, is essential not only for monetary policy to be truly effective, but also for it to remain effective in the future. Ryan Avent over at The Economist discusses the issue with regards to the current debate surrounding the FED’s “tapering”:

I understand that the Fed is generally uncomfortable with unconventional monetary policy and has concerns about the side-effects from large-scale QE. That’s eminently reasonable. The trouble is that the Fed seems not to have learned that aiming to overshoot on the pace of employment growth and inflation is the safer, more conservative route. Overshooting maximises the chance that monetary policy will maintain its potency the next time trouble hits. Overshooting provides the best means to safely and quickly end growth in the balance sheet. Overshooting is the sustainable route to healthy increases in interest rates. But overshooting, the Fed has made entirely clear, is the one thing the American economy should not expect.

And the risks involved in not overshooting have become even more clear in the aftermath of the recent crisis, as discussed by Yichuan Wang, who seems to hit the nail on the head with this statement with regards to how the FED got stuck in the liquidity trap in the first place:

It is important to remember the sequence of these events. It is easy to think that the downward pressure on interest rates was the inevitable consequence of financial troubles. […] The Fed’s sluggishness to act is even more peculiar given that there were already serious concerns about economic distress in late 2007. [T]he decision to wait three months to lower interest rates to zero was a conscious one, and one that helped to precipitate the single largest quarterly drop in nominal GDP in postwar history. The chaos in the markets did not cause monetary policy to lose control. Rather, the Fed’s own monetary policy errors forced it up against the zero lower bound.

In a way monetary policy (and not just by the FED) made the same mistake as fiscal policy in the aftermath of the crisis – it tried to be optimistic, “on the safe side” of things, and ended up providing stimulus that ended up being massively inadequate. Not only does this mean it now faces a much deeper slump than necessary, making its job much more difficult. It also means that the very ability of it to do its job is put in question. Just like the “failure” of the Obama stimulus plans to keep unemployment in the single digits has been the main argument against fiscal stimulus in general, monetary policy being stuck in a “liquidity trap” that it to some degree helped create in the first place has also been the main argument for those who say monetary policy can’t do anything more either!

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