Baby it’s cold outside: monetary policy as outer wear

April 19, 2013

Discussions about central banking are often belabored by analogies to moving vehicles, which make some sense given that interest rate policy can act both as accelerator and brake on economic activity. Perhaps tired of being in the driver’s seat, Minnesota Fed President Narayana Kocherlakota decide to switch gears and talk about clothing instead.

In an attempt to illustrate that interest rates are low because of economic conditions, not the whim of policymakers, Kocherlakota compares monetary policy to a protective jacket that needs to be worn when the weather gets rough but can slowly be removed as the summer approaches.

Why have real interest rates fallen so much? At one level, the answer is obvious: monetary policy. The FOMC has announced its intention to keep the fed funds rate near zero at least until the unemployment rate falls below 6.5 percent. At the same time, the FOMC has bought over $3 trillion of longer-term assets issued or backed by the government. With inflationary expectations well anchored, these actions are designed to push downward on real interest rates and have been successful in doing so.

But I think that the obvious monetary policy answer is actually deeply misleading. Consider the following, very Minnesota, analogy. Some days during the year when I go outside, I wear a parka. Other days, I wear a light jacket. And-this will seem hard to believe-on some other days, I don’t need a coat at all.

Every morning, I have complete control over what kind of coat I wear-even more control than the FOMC has over real interest rates. But, of course, in making my choice of outerwear, I’m merely responding to the Minnesota weather, which is a force that is-sadly-well beyond my control. The FOMC is in exactly the same position of having to respond to strong forces well beyond its control when making its decisions about the real interest rate. Thus, when I decide what coat to wear, my goal is to keep myself at a temperature that I view as appropriate, given prevailing conditions that I cannot influence. Similarly, when the FOMC decides on a level of the real interest rate, its goal is to keep the macroeconomy at an appropriate ‘temperature,’ given prevailing conditions that it cannot influence.

For Kocherlakota, who recently had a pretty big change of heart on policy, the Fed is not doing enough to stay toasty.

The truth is that the FOMC’s choice of winter garb is actually insufficient to keep the U.S. economy appropriately warm. After all, the outlook for both employment and prices is too low relative to the FOMC’s goals. Unemployment is currently 7.6 percent and is expected to fall only slowly. At the same time, inflation pressures are muted: Both private sector forecasters and the FOMC expect that PCE inflation will be at or below 2 percent through 2013 and 2014. The Committee needs to put on some more serious winter gear if it is to get the economy back to the right temperature. More prosaically, the FOMC can only achieve its dual mandate objectives by lowering the real interest rate even further below its 2007 level.

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