New York Times columnist Paul Krugman writes today that it's too early to begin removing the monetary stimulus engineered by the Federal Reserve.
"A few months ago the U.S. economy was in danger of falling into depression," he notes in his column. "Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual. Those demands should be ignored. It’s much too soon to give up on policies that have, at most, pulled us a few inches back from the edge of the abyss."
He may be right…or not. Debating the correct monetary policy is always topical in real time, and always unclear. As it happens, the stakes are unusually high in the current debate. The future, however, isn't necessarily any clearer, nor is it apparent that the Federal Reserve has suddenly transformed itself into an institution with omniscient powers.
Following the 2000-2002 bear market, the Federal Reserve decided that unusually low interest rates were necessary—for several years! Even though the economy had obviously recovered and was expanding at a healthy clip in 2003 and 2004, the central bank kept the price of money excessively low. The error didn't necessarily inflame inflation risk, but it did contribute to excessive investment in, among other areas, real estate by creating abnormal incentives for borrowing. Nor was this the first time that the Fed misjudged monetary policy.
Now we're faced with another potentially far-reaching decision on monetary policy. It's tempting to proclaim that all's clear and so it's timely to do this or that. But history reminds that what's obvious looking ahead may turn out differently after the fact.
Prudence suggests that there's no reason why monetary policy must go from one extreme to another overnight. If the central bank had full transparency about the future, and that spilled over into complete clarity about monetary policy in real time, there'd be a case for sharp, dramatic changes to the interest rates. But ours is a world of constantly grappling for perspective, day by day, using imperfect information that's out of date. Our forecasts are, at best, only partly reliable and so our policy responses must evolve rather than lurch from one regime to another.
With that in mind, it's clear that interest rates should rise going forward, but there's a great debate about how far they should rise and when the ascent should commence. Since we don't really have a good answer, we must hedge our bets. On the one hand, we can't let inflation out of the bag. Given the massive liquidity injections of late, and the inflation-prone history of fiat currencies, this is no idle threat.
At the same time, the risk of continued economic weakness shouldn't be dismissed either. There are reasons to be hopeful that that recession may be over, but it's still far from clear that the recovery will be robust or even long-lasting, as we discussed on Friday.
Navigating between these two extremes is the only reasonable strategy for mere mortals at this point until we have a better handle on discounting the economic future. Perhaps we'll have a clearer view in the weeks ahead; perhaps not. That said, the risk of maintaining the status quo for monetary policy still look minimal. But unless the next few weeks offer compelling evidence otherwise, it'll be soon time to begin raising rates, albeit marginally if only to show the market that the Fed is serious about fighting inflation in the future, if necessary.
Should we raise Fed funds to 1% next week? Of course not. But neither can we rule out a target rate adjustment to 0.25%-to-0.5% next month or perhaps the month after. Perhaps that will suffice for six months or longer, depending on what the data tell us.
If Churchill was a central banker he might advise that gradualism is the worst possible approach to monetary policy in a world of uncertainty—except when compared to everything else.
This post can also be viewed on capitalspectator.com.