Fed Talks Thresholds, Operation Twist

Economists are predicting what the Federal Reserve will tackle at is next Open Market Committee (FOMC) meeting and the two first guesses include policy guideline discussions and a look at Operation Twist. On the first topic, many Fed execs want to make clear that unemployment cannot be the only beacon for determining threshold levels. Regarding Operation Twist, or how the Fed will hand large-scale asset purchases, many economists feel that the move to an outright asset purchase program signifies an easing of current policy, although a final determination must involve the outcome of the fiscal cliff. For more on this continue reading the following article from Economist’s View. 

Tim Duy:

Monetary Policy to Become Easier Next Week?, by Tim Duy: There are two important issues to be discussed at next week's FOMC meeting. One is the issue of specific thresholds as future policy guides. The second is the replacement for Operation Twist. Clearly, support is building for specific thresholds, and I believe policymakers will work out the details within the next meeting or two. Also, I think the general sense is that the Fed will continue to purchase long-term Treasuries after Operation Twist is complete. But will they continue to purchase the full $45 billion a month? That seems like it should be an open question, but it looks like momentum is building in that direction.
St. Louis Federal Reserve President James Bullard offered his thoughts on both these topics yesterday. On the first point, he offers support for replacing the forward guidance with a set of thresholds. I don't find this to be surprising. Bullard has never been a huge fan of the time commitment implied in the current statement. Not only does it send a pessimistic signal about the economy, in theory it should respond more flexibly to evolving economic events. But in practice, the Fed is only willing to alter the date in the event of a substantial shift in the economic outlook.
Bullard cites the 6.5/2.5 unemployment/inflation thresholds recently described by Chicago Federal Reserve President Charles Evans. I am not sure that Bullard specifically endorses these figures, but he may sense the political wind is blowing in that direction. He nicely describes six challenges to a threshold regime:

1. The Fed needs to make clear that in the long-run the Fed cannot target unemployment.
2. He believes the threshold should be on actual outcomes, not forecasts.
3. The Fed needs to communicate that policy is about more than just two variables. For example, he suggests the possibility of raising interest rates to limit asset price bubbles.
4. Unemployment is not the only measure of the labor market. The Fed takes a broader view of labor markets into consideration.
5. Unemployment can remain high, such as in Europe (I think this is really just a restatement of point one).
6. Beware that thresholds will be viewed as triggers, which they are not.

I think these are valid concerns the Fed needs to address as the communication strategy evolves. Bullard then shifts gears to Operation Twist. Currently, large scale asset purchases come in two flavors. One is $40 billion a month in outright mortgage purchases (QE3), the other a monthly swap of $45 billion in short-term Treasuries for an equal amount of long-term Treasuries (Operation Twist). The former is open-ended, the latter concludes this month. Should it be fully converted to an outright asset purchase program? San Francisco Federal Reserve President John Williams gave his opinion last month:

Meeting with reporters following a speech at the University of San Francisco, MNI asked Williams whether he thinks the FOMC should replace the Operation Twist Treasury purchases dollar for dollar upon their expiration Dec. 31. He answered strongly in the affirmative.
"My view is based on the expectation that we won't see substantial improvement in the labor market" for awhile, Williams said, adding that therefore "my view is that we should continue with purchases of long-term Treasuries after December into next year."
Williams said he favors "just purely buying long-term Treasuries at the rate we're buying."
Asked to clarify, Williams said he favors buying MBS and Treasuries "at the same rate we're doing now" -- $85 billion per month.

Boston Federal Reserve President Eric Rosengren agreed yesterday. Operation Twist changes the composition of the balance sheet, not its size. If the Fed converts to an outright asset purchase program, they will more than double the pace of net purchases. In my opinion, this appears to be a substantial easing of policy. Bullard feels similarly:

...on balance I think it is reasonable to think that an outright purchase program has more impact on inflation and inflation expectations than a twist program....
...Replacing the expiring twist program one-for-one with outright purchases of longer-dated Treasuries is likely more dovish than current policy.

I think that is correct; the conversion of Operation Twist should be considered a more aggressive policy. Yet inflation expectations (with the usual caveats about TIPS based expectations) continue to wane:

Perhaps financial market participants do not expect the Fed to commit to the full $85 billion in purchases. But this does not seem to be the case. There has been more than enough Fedspeak to suggest that additional easing is coming. Which leads me again to wonder if monetary policy is now at full throttle? $40, $50, or $85 billion a month. Does it make a difference? Or is the expectation of additional easing simply offsetting expectations of tighter fiscal policy?

Bottom Line: The Fed is gearing up to convert Operation Twist to an outright purchase program. A complete conversion should be considered a more aggressive policy stance. If the Fed wants to hold policy constant, then we would expect a less than one-for-one conversion. There are reasons to expect the Fed would go the full monty. Notably, the fiscal cliff drama already appears to be affecting the economy, even though it is more risk than reality. But why are inflation expectations sliding? And what does that imply about the effectiveness of additional easing at this juncture? Important but as of yet unanswered questions.

 This post was republished with permission from The Economist's View.

Expert Ponders Fed Policies, Plans

Economist Tim Duy would like to reconcile the Federal Reserve’s near-term and long-term plans for fiscal responsibility with the real state of the U.S. economy but has trouble connecting the dots. He believes its attempt to hit very specific targets will likely fail to due to its inability to communicate needs across channels as well as a seeming disconnect with the fact that the economy is not in a mode of full recovery. He argues that increased government spending may be able to break the cycle of stagnation that is being caused by restricting natural inflation, otherwise fiscal austerity and another recession may take root. For more on this continue reading the following article from Economist’s View.

Tim Duy:

On Coordinated Monetary and Fiscal Policy, by Tim Duy: Note: This began as an effort to tie together various themes in my writing. Unfortunately, short and succinct did not work. So I apologize in advance for the length of this post.

There are certainly trends in my writing. One is that the Federal Reserve spent much of this year behind the curve by failing to adapt their large scale asset purchase program or their communication strategy to the reality of a persistently weak economy. The Federal Reserve effectively dealt with that issue at the last FOMC meeting.

To be sure, I can quibble with some of the specifics, such as a lack of more explicit economic targets and a clear commitment to near term-irresponsibility by allowing inflation to rise above 2 percent when (or if) the economy gathers steam. On the first issue, I am coming around to the thinking that while explicit targets (other than inflation or nominal GDP) might sound good in theory, in practice trying to tie policy to a constellation of price and output targets risks becoming a communications nightmare. The Fed needs to tread very carefully on this point; it may be best for them to fall back on that old adage about pornography. We will know a "sufficient and sustainable" recovery when we see it.

The second issue, a promise to be irresponsible on inflation, remains unlikely as long as the Fed continues to stress it will take actions "in the context of price stability." I don't view a temporary increase in inflation as necessarily undermining neither the Fed's long-term inflation targets nor a nominal GDP target. And I think that the failure to make such a promise could very well disrupt a reversion of the economy to pre-recession trends. This I will discuss further later.

Another trend in my writing is that there needs to be some coordination between fiscal and monetary policy. Putting aside what I believe will be an aberration in the third quarter, authorities are already engaged in some degree of fiscal austerity:

and have effectively promised to do more. Should it even be reached, a compromise to the fiscal cliff will likely still be further austerity. I think that we should be wary about underestimating the impact of such austerity, especially as it is increasingly evident that multipliers are larger than expected at the zero bound. Fiscal austerity would likely be a key factor in maintaining the relatively tepid pace of the recovery into 2013. Moreover, fiscal austerity wastes the opportunity provided by a low interest rate environment. The Federal Reserve has already promised to buy a steady stream of assets from the financial markets. All Congress needs to do is sell debt into that stream. No explicit coordination necessary.

Another issue that I can't run away from is the potentially negative impacts of a sustained zero interest rate environment. It would be a mistake to believe that monetary policy does not have distributional impacts. Low interest rates obviously hurt savers:

Moreover, we should be concerned about distortions to the capital allocation process. Encouraging excessive risk taking now will come back to haunt us later. That said, it is necessary to balance such negative impacts against the positive impacts. Nor is it clear that the Federal Reserve is driving this train; the absence of an aggressive monetary policy might very well weaken the economy such that interest rates fall further. In any event, I am challenged to see how a different monetary policy would be effective; tightening policy at this juncture would likely be disastrous for the economy.

Finally, another issue to which I have already alluded is a belief that the US economy is on a suboptimal path:

This is obviously controversial. For example, St. Louis Federal Reserve President James Bullard has repeatedly said there is only one path, and we are on it. The appropriate monetary and fiscal reaction functions are obviously different in a such a world. In such a world monetary policy leads only to potentially greater inflation with little impact on growth.
Jumbled as it might seem due to the nature of blogging, somewhere in the background I have a framework that ties this altogether. And I was reminded by a colleague that I had seen that framework presented by another colleague, George Evans. The associated paper, "The Stagnation Regime of the New Keynesian Model and Recent US Policy" is here.
Evans begins with a New Keynesian in which expectations are formed by adaptive learning. An outcome of the model is that a sufficiently large negative shock can push the economy into a deflationary trap. Interestingly, agents learn their way into the trap by forming pessimistic expectations of future economic outcomes. My interpretation is that agents learn to live in what is often called the "new normal" and as a consequence make decisions that ensure the the new normal is a stable equilibrium.
The model is subsequently modified to account for nominal wage rigidities such that the low equilibrium trap, the stagnation regime, has an inflation floor. Another characteristic of the regime is low levels of output and consumption in which welfare is potentially much lower than the preferred equilibrium.
How can we break out of the stagnation regime? A temporary increase in government spending that is sufficiently large to allow a self-sustaining process to take over. The economy reaches an escape velocity such that agents learn there way allow a dynamic path to the preferred locally stable, higher equilibrium. At such a point, government spending can revert to normal without threatening a recession.
Monetary policy can also come into play, but Evans is less optimistic that the Federal Reserve is capable of breaking the US economy out of the trap. He notes that even promises of low rates forever may not be enough if the economy has suffered a sufficiently large negative shock. Evans adds that quantitative easing can support the economy via lowering long-term rates and stimulating demand, but also warns:

An additional problem, however, is that there are some distributional consequences that are not benign. Households that are savers, with a portfolio consisting primarily in safe assets like short maturity government bonds, have already been adversely affected by a monetary policy in which the nominal returns on these assets has been pushed down to near zero. A policy commitment at this juncture, which pairs an extended period of continued near zero interest rates with a commitment to use quantitative easing aggressively in order to increase inflation, has a downside of adversely affecting the wealth position of households who are savers aiming for a low risk portfolio.

There is a lot to digest in a short paper, but I encourage making the effort.
Thinking in terms of this model, it is immediately clear that one should be very concerned with impending fiscal austerity unless you believed the economy had already reached escape velocity (I don't). Moreover, you should be concerned about austerity even in context of the evolution of monetary policy into QE3 as it is not clear that the Fed can by itself push the economy to escape velocity. The Fed is literally stuck between a rock and a hard place, with the stimulative force of lower rates for borrowers traded off against lower income for savers, a point that Ed Harrison often makes. And the more we lean on monetary policy, the tighter that space gets. Yet we have little choice with a political environment that favors austerity over stimulus.
In addition, one should be concerned about the fragility of any recovery based upon a Fed-induced effort to achieve escape velocity. This is especially the case if the Fed has not promised (and whether such a promise is credible is another question) to be irresponsible in the transition to the higher equilibrium. Consider that the CBO projection for GDP growth is 4.8% in 2015. This, I suspect, is the kind of number needed to achieve escape velocity. But consider the Fed's reaction function in the face of such growth in the context of 1.) price stability and 2.) internal concerns about the ability to unwind quantitative easing. I think under those circumstance policymakers would error on the of tighter, faster rather than allowing a temporary acceleration of inflation.
The last paragraph brings up an interesting question. Even if the Fed promised to allow inflation to accelerate and did so, eventually they would tighten policy just the same. Which means the same recession, just a year later. 2015 or 2016. 2017 at the latest.
The problem is that the recovery is pretty much held together by debt refinancing, cheap mortgages and higher asset prices; by such measures, monetary policy has been successful! To be sure, there has been some debt reduction on the part of households:

But it is limited in comparison of the ability of households to utilize lower interest rates to reduce the cost of financing that debt:

I think in the near-term those who believe the monetary authority is the only answer will appear correct as the recovery progresses. Indeed, Annie Lowrey at the New York Times reports that household debt is now increasing for the first time since the Great Recession began. From a broad macroeconomic perspective, this is a near-term positive, and creates reason to believe that monetary policy will cushion the impacts of whatever flavor of the fiscal cliff we experience.

But I don't think this will be a stable long-term result. Obviously, I could be wrong, but it seems to me that we are using the same trick we have been using since the mid-1980's - lowering debt financing costs, thus allowing for a greater debt burden. This trick will continue to work as long as there is room to push interest rates further down. Now that we are at the zero bound in short-term rates and the Fed has been forced to move quite far out the yield curve to implement monetary policy, it is likely this is the last time that trick will work. There will not be much room to refinance our way out of trouble the next time around. Hence why I concerned about still being at the zero bound when the next recession hits.

Moreover, I would find it unlikely that we pass through another two or more years of zero interest rates without seeing capital mis-allocations, assets bubbles, and excessive risk taking. In such an environment, I don't think the Fed is going to be particularly successful in moving the economy off the zero bound without triggering a fresh recession.

Now, it would be easy to take this as criticism of the Federal Reserve. It isn't. The Fed should have moved to open-ended QE long ago to end the problem of arbitrary end dates to policy and needed to clean up its communication strategy to make clear the economic outcomes would define when QE would end. And, probably most importantly, the Fed is compensating for a dysfunctional US political process. I know there is one view (see Raghuram Rajan) that the Fed is simply enabling that process. Perhaps Congress would do the "right" thing if push comes to shove. But what is the "right" thing? If Congress were left to its own devices, would it take us down the road of fiscal stimulus sufficient to spring the economy from the stagnation trap? Or would they continue down the road of additional fiscal stimulus, driving the economy deeper into the trap? My sense is that Congress would find additional austerity to be the path of least resistance. Pete Peterson has won. The Congressional deck is stacked against the economy. And I think Federal Reserve Chairman Ben Bernanke knows this.

Putting all the piece together, I tend to think that neither fiscal nor monetary policy by itself will support a sustained recovery in which the interest rate environment normalizes and fiscal stimulus can be eliminated without fear of renewed recession. The two need to work hand in hand; the Federal Reserve has provided the monetary environment conducive to additional fiscal stimulus. Congress and the Administration now need to take advantage of the environment. Or, alternatively, if the fiscal authorities are not issuing sufficient new financial assets such that there is upward pressure on interest rates, they need to be issuing more.

In conclusion, the above framework both praises the direction of monetary policy without discounting concerns about the dangers of the permanent zero bound policy. A framework that allows for both accepting near-term growth on the back of monetary policy but also concern about the sustainability of that policy. A framework that decisively rejects additional austerity on a simple basis that it will not help normalize the interest rate environment. If nominal rates were 8% then yes, fiscal austerity would help normalize the interest rate environment. But that simply isn't the current situation. Perhaps, if we are lucky, it will be a problem in the future.

I realize that it would probably be easier if I could find myself either advocating the primacy of monetary policy in determining the level of output or deriding the Federal Reserve for the evils of the quantitative easing. Or if I could fully embrace fiscal stimulus as the only solution or austerity as the only solution. Picking one of those quadrant and defending it absolutely would probably make me more friends that straddling all four quadrants at once. But absolute devotion to one quadrant is probably not the right answer. I tend to believe that the right answer is a more complicated mix of monetary and fiscal policy than is currently employed. And don't think we can get to that right mix if we lock ourselves into an ideological box. Hence why I try to avoid such boxes.

Again, sorry for the long post.

Fed Moving Toward “QE3”

The Federal Reserve’s answer to woeful economic performance since the onset of the recession in 2008 is to print more money to buy up U.S. government debt in a move described as “quantitative easing.” Now it appears that despite Chairman Ben Bernanke’s stance that the Fed was through with this practice following the end of QE2, there will be a need for another round of “easing” to keep stocks from plummeting as unemployment rises. The theory is that the stimulus encourages borrowing and spending by keeping interest rates lower while buying more time for a turnaround without default, but without sound policy decisions being made in the interim it just amounts to a delay of the inevitable. For more on this continue reading the following article from Tim Iacono.

It would appear that the magic elixir of a two-year pledge for freakishly low interest rates from the Federal Reserve has an effective life of only about 18 hours since, after yesterday’s remarkable 400+ point move higher for the Dow Jones Industrial Average, that gain has been reversed in trading today, markets effectively telling Ben Bernanke and the rest of the staff at the central bank, “What else you got?”

Recall that, yesterday, the Fed fired off the first of a possible three shots that could be seen prior to what some analysts predict will be another $1 trillion or so in outright money printing to buy government debt or some other asset that, if all goes well, would goose the markets for another six months or so, just like it did last year.

After the low rate promise yesterday, what’s likely to be heard next from the Fed is: a) they intend to lower the interest paid on excess reserves to compel banks to lend a little more, or b) they’re going to fiddle with the two trillion dollars in assets they’ve purchased in recent years to somehow convince somebody to do something that would somehow right the quickly sinking ship.

Neither of these steps are likely to have a more lasting impact than yesterday’s move, so, what we’re really looking at here is either the Fed can embark on QE3 and, if all goes well, boost asset prices until mid-2012, or they can sit on their hands and watch the stock market fall further while the jobless rate rises.

Based on the three dissenting votes for yesterday’s action, any subsequent moves by the Fed will be met with similar disapproval by some voting members, however, that’s not likely to stop the doves from printing up another trillion dollars or so for the greater good.

After yesterday’s baby step in that direction, Goldman Sachs said today that QE3 sometime later this year or in early-2012 is now likely and, based on how markets are moving today, it’s hard to disagree with that view, the only variable seeming to be the size and the timing.

With the Dow now closing in on bear market territory while other stock indexes have already breached that level, you’d think that it won’t take too much more of this for the Fed to act. Moreover, the only way that we’ll likely make it to the Jackson Hole group therapy session in two weeks (where a major policy initiative could be announced) without an even more severe breakdown in equity markets is if all the Fed doves start making speeches about QE3 – when, how much, and how they see this as the best of a handful of policy options.

They’re probably already working on those speeches…

This blog post was republished with permission from Tim Iacono.

Bernanke Willing To Use Monetary Policy To Fight Asset Bubbles

Ben Bernanke says that monetary policy was not a primary cause of the housing bubble but is ready to consider raising interest rates to fight future bubbles if regulation fails. Mark Thomas calls this an evolution from Alan Greenspan's philosophy in which he argued that the Fed could not identify bubbles as they were inflating with sufficient clarity and believed that raising interest rates was just as likely to cause harm. See the following post from Economist's View for more on this.

Ben Bernanke says Federal Reserve interest rate policy after the dot.com bubble burst did not cause the housing bubble, and he delivers a strong rebuttal to John Taylor on that point. He argues the problem was with the regulation of these markets, not the low interest rates after the dot.com crash, and based upon this reading of the causes of the crisis, he believes regulation is the key to preventing bubbles. But he also acknowledges that if regulation fails to get the job done, then the Fed must step in and pop bubbles before they get too large by raising interest rates (though doubts are expressed about whether increasing interest rates would have done much to stop the bubble, hence the strong preference for regulatory solutions).

This is a big step forward relative to the Greenspan years. Greenspan argued that the Fed could not identify bubbles as they are inflating with sufficient clarity to allow policy to do much about them, he thought the Fed was as likely to do harm from raising interest rates based upon false bubble alarms as it was to prevent problems. And in any case, he believed that cleaning up after bubbles popped would be enough to avoid large downturns like we are experiencing. The best that the Fed could do given the difficulty in identifying bubbles ex-ante is to clean up after they self-identify by popping, but that would be more than enough to keep the economy from experiencing big crashes.

Greenspan's view that cleaning up ex-post would be sufficient to insulate the economy from large shocks turned out to be incorrect. He also resisted and actively dismissed regulatory interventions intended to keep the financial sector stable and keep bubbles from inflating in the first place, and this, too, was a mistake. In the past, Bernanke and other members of the Fed have also been resistant to using interest rate policy (as opposed to regulation) to prevent bubbles, so this is an evolution in the Fed's view of its role in preventing asset price bubbles from threatening the stability of the broader economy.

The Fed still strongly prefers regulatory solutions, the main problem with interest solutions are that bubbles are hard to identify, and even if you do identify them, interest rate increases affect all industries, not just the one experiencing the bubble, so the policy inflicts collateral damage (though perhaps less collateral damage than if the bubble actually pops). In this regard, I wish Bernanke would have talked about how the Fed might find better measures of growing financial market imbalances, measures that would allow it to better identify bubbles a priori. We can use interest rate and regulatory policy to fight bubbles much better and target policy more precisely if we have more certainty about the existence of bubbles as they are inflating, but that will require the Fed to develop much better measures of financial market fragility than it now has. (This is an alternative to incorporating asset prices into the index the Fed targets through its implicit Taylor rule, something that automatically raises interest rates when asset prices increase substantially and something that I've advocated in the past. Incorporating asset prices into the inflation index the Fed stabilizes is a very broad-brushed approach to the problem of fighting bubbles, so more targeted approaches are preferable). I realize that we have models saying it isn't possible to identify bubbles as they are inflating, but models aren't reality - they aren't always correct - and we won't really know until we try:

Monetary Policy and the Housing Bubble, Ben S. Bernanke, Chair, FRB: The financial crisis that began in August 2007 has been the most severe of the post-World War II era and, very possibly--once one takes into account the global scope of the crisis, its broad effects on a range of markets and institutions, and the number of systemically critical financial institutions that failed or came close to failure--the worst in modern history. Although forceful responses by policymakers around the world avoided an utter collapse of the global financial system in the fall of 2008, the crisis was nevertheless sufficiently intense to spark a deep global recession from which we are only now beginning to recover.

Even as we continue working to stabilize our financial system and reinvigorate our economy, it is essential that we learn the lessons of the crisis so that we can prevent it from happening again. Because the crisis was so complex, its lessons are many, and they are not always straightforward. Surely, both the private sector and financial regulators must improve their ability to monitor and control risk-taking. The crisis revealed not only weaknesses in regulators' oversight of financial institutions, but also, more fundamentally, important gaps in the architecture of financial regulation around the world. For our part, the Federal Reserve has been working hard to identify problems and to improve and strengthen our supervisory policies and practices, and we have advocated substantial legislative and regulatory reforms to address problems exposed by the crisis.

As with regulatory policy, we must discern the lessons of the crisis for monetary policy. However, the nature of those lessons is controversial. Some observers have assigned monetary policy a central role in the crisis. Specifically, they claim that excessively easy monetary policy by the Federal Reserve in the first half of the decade helped cause a bubble in house prices in the United States, a bubble whose inevitable collapse proved a major source of the financial and economic stresses of the past two years. Proponents of this view typically argue for a substantially greater role for monetary policy in preventing and controlling bubbles in the prices of housing and other assets. In contrast, others have taken the position that policy was appropriate for the macroeconomic conditions that prevailed, and that it was neither a principal cause of the housing bubble nor the right tool for controlling the increase in house prices. Obviously, in light of the economic damage inflicted by the collapses of two asset price bubbles over the past decade, a great deal more than historical accuracy rides on the resolution of this debate.

The goal of my remarks today is to shed some light on these questions. I will first review U.S. monetary policy in the aftermath of the 2001 recession and assess whether the policy was appropriate, given the state of the economy at that time and the information that was available to policymakers. I will then discuss some evidence on the sources of the U.S. housing bubble, including the role of monetary policy. Finally, I will draw some lessons for future monetary and regulatory policies.1

You can view the full speech at the Federal Reserve site.

This post has been republished from Mark Thoma's blog, Economist's View.

Should Obama Scale Back Efforts To Fight The Recession?

Now that an economic recovery looks imminent, some individuals are calling for less monetary intervention to stimulate the economy. This probably stems from worries that the current monetary policy will lead to dangerous financial repercussions in the future. Should the Fed and government scale back their expensive efforts to fight the recession, now that a recovery seems close? James Picerno from The Capital Spectator tackles this topic below.

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.