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Economy in Brief

"Opportunistic" Strategy for the Fed
by Joseph G. Carson ([email protected])  Janaury 18, 2019

Federal Reserve officials are between a rock and a hard place. Even though economic growth has topped policymaker’s expectations turbulence in the financial markets due to fear of tighter monetary conditions and the risk of a trade war with China forced policymakers to signal a pause in their plans of additional hikes in official rates. Yet, as financial markets steady and the trade issue is resolved or reduced in scale policymakers need to regain the narrative, as the overall stance of monetary policy, given the economic and financial backdrop, remains too accommodative. One-way policymakers could move forward is by adopting an "opportunistic" policy in order to complete their plan to normalize monetary policy while also fulfilling the mandates of full employment, price stability and financial stability. Let me explain.

An "opportunistic" strategy for monetary policy was developed many years ago and its main goal was to lock-in the lower rates of inflation that are often triggered by weak economic conditions or even favorable supply shocks. The thinking behind this strategy was that a gradual step-down in the rate of underlying inflation should be the goal of a successful monetary policy. Accordingly, policymakers could use each successive period of slow or negative growth to reset lower its inflation target and eventually end up (opportunistically) with an underlying rate of inflation that is considered to be price stability.

A similar strategy could also be used to reset official rates to a "neutral" target and even establish a new equilibrium level for the Fed’s balance sheet. How this would work in practice is that policymakers would set targets (not publically disclosed) for official rates and even the level of the balance sheet and use every window of opportunity (i.e., periods of steady growth and stable financial markets) to move closer to the goals.

The benefits of this strategy are twofold. First, the announcement of an "opportunistic" normalization policy would immediately send the signal that policymakers have the flexibility (even if never used) to hike official rates when financial markets are stable and not just pause or cut rates when financial markets are volatile. That may not completely eliminate the so-called Fed "put", or the notion that the Fed will often take action to support financial asset prices in times of extreme volatility, but it would at least instill two-way risk in investing.

Second, an "opportunistic" monetary policy would also facilitate the restart of preemptive policy moves, enabling policymakers to get ahead of perceived risks, whether they are economic or financial. Preemptive moves in monetary policy had been a long held practice as it was felt that modest preemptive actions could obviate the need for more drastic or larger moves at a later date. Preemptive policy moves were often used against economic and financial conditions that were seen to trigger a cyclical rise in inflation, but they were also used in periods of acute financial stress, as was the case during the risk of potential contagion from the Asian crisis as well as the Long-Term Capital Management debacle in 1998.

For example, during an 8-year stretch, from the start of 1994 to the end of 2001, the Federal Reserve moved official rates up and down a total of 31 times, 13 of which were more than 25 basis points, and most of the moves were not telegraphed ahead of time. And, during this long period core consumer price inflation never posted annual rate of inflation over 3% or under 2%.

Policymakers have cited the recent "muted" inflation readings as a reason to be patient with the normalization of monetary policy. Yet, general inflation has not been a destabilizing force in the economy for the past 30 years. To be sure, each of the past two recessions started with core consumer inflation around 2.5%, or very close to the current inflation rate of 2.2%. Instead, destabilizing excesses in the financial markets triggered the last two recessions. And today’s elevated level of asset prices, huge financial balances and high levels of debt risk a replay.

As risks have shifted from general "inflation" to financial "excesses" policymakers still need to employ a risk management policy and by adopting an "opportunistic" strategy policymakers would gain added flexibility with the interest rate lever to dampen financial conditions that could at some point unwind and destabilize the economy just as high periods of inflation did in the past.

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