Sunday, November 18, 2007

If Fed Can't Fine-Tune, It Should Focus on Inflation

Notice in the chart above that over the last 7 years the Federal Reserve has moved the target Fed Funds rate (blue line) from 6% in early 2001 to 1% for about 12 months from mid-2003 to mid-2004, and then back up 5.25% from mid-2006 to mid-2007, and now it's back down to 4.5%.

And yet despite the 5 percent range (1% to 6%) in the target Fed Funds rate, the 10-year T-note yield has mostly stayed within a half percentage point of its 4.52% average yield during this period. In about 80% of the months from 2001-2007 the 10-year T-note yield stayed within a narrow 1 percentage point range between 4-5%, and varied just slightly above 5% and slightly below 4% with equal frequency the rest of the time.

Bottom Line: The Fed can move its target short-term Fed Funds target rate up and down by a huge 5 percentage point range from a low of 1% to a high of 6%, with no significant effect on long-term rates. If the Fed can't make long-term interest rates change when it makes dramatic changes in monetary policy, doesn't that mean the Fed is largely ineffective at discretionary, activist, countercyclical fine-tuning and instead should just focus exclusively on an inflation target?


At 11/19/2007 8:20 AM, Blogger Ironman said...

For one thing, it's nice to see the Fed's power has limits!

More to the point, where the Fed's policies have the most impact lies in their ability to affect short term interest rates. So long as the Fed maintains adequate "stewardship" (for lack of a better word - I know "control" definitely isn't it) over these rates, the long term rates will and should be comparatively stable over time.

The reason why is straightforward - an inability to adjust policy to control inflation in the short term will result in long term rates rising as these expectations get built into the market at large. Meanwhile, establishing a more effective inflation control policy would see these rates decline.

Since there is enough marginal economic activity that's affected by short term rates, the Fed does have some countercyclical economy tuning ability. Unfortunately, political pressure for policy changes is at its greatest in these same short term periods.

Because of that factor, I don't expect the Fed will ever be able to move to a pure inflationary target. They had their chance in the pre-Humphrey-Hawkins era, and they blew it.

At 11/19/2007 9:43 AM, Anonymous Anonymous said...

Hey Mark --

Why did you delete your ill-timed post from last week about how the bank stocks were coming back -- and that was a sign of the end of the credit crisis? Are you engaging in revisionist history?

At 11/19/2007 10:45 AM, Anonymous Anonymous said...

Dr Perry must be saving that post for a time when banks are actually recovering!! Maybe, Dr. Perry makes up all of these post ahead of time. He posted the wrong one that day...

At 11/19/2007 2:22 PM, Blogger Malachi said...

Don't we need to know the number of 10-year T-notes put on the market by the Treasury during that period of time before we can draw conclusions?

At 11/20/2007 11:56 AM, Anonymous Anonymous said...

Mark and his buddy Kudlow are in denial about the lagging economy and credit crunch.

"Inflation? What inflation? I can buy Ipods on the cheap and $25 DVD players. The fundamentals are fine. Core inflation is only 2%."


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