October 27, 2015 Reading Time: 4 minutes

interest-rates

Everyone seems to have an opinion on when the Fed should raise rates (including Fed officials). Many of theses views are as misguided as the common notion of what it is that the Fed actually does. As I have explained before, the Fed doesn’t set the federal funds rate. It merely chooses its federal funds rate target. Likewise, it doesn’t raise (or lower or maintain) the federal funds rate. It merely raises (or lowers or maintains) its federal funds rate target. I cannot stress how much I dislike the current fixation with interest rates in monetary policy debates. But, given the current rate-targeting regime, one might reasonably consider when the Fed should raise its federal funds rate target.

There are at least two situations in which it would make sense for the Fed to raise its target rate. Raising its target rate in either of these cases would not prompt economic decline, as proponents of so-called rate hikes fear. Indeed, failing to raise its target rate in these cases might result in production below the economy’s sustainable potential or the propagation of an unsustainable boom. Let’s tackle them one at a time.

1. Inflation is too low.

The federal funds rate is a nominal interest rate. As Irving Fisher explained, nominal rates depend on the real equilibrium rate of interest—that is, the rate consistent with the amount of real resources borrowers are willing to repay and lenders are willing to accept on the margin—and the amount of inflation they expect over the period of the loan. If officials at the Fed believe inflation is too low at the moment, the appropriate course of action is to (a) clearly articulate the rate of inflation they intend to achieve so that agents can form accurate expectations about future inflation and (b) increase the growth rate of the monetary base to bring about the desired inflation. As inflation expectations increase, so too would the nominal interest rate. The Fed would have to raise its interest rate target to prevent generating an unsustainable boom.

Is inflation too low? Well, it is certainly below the Fed’s stated policy goal of 2 percent. Inflation, as measured by the consumer price index, averaged just 0.46 percent over the last year. Observing a rate of inflation below the Fed’s stated goal does not imply the inflation rate is too low, though. That depends, for one thing, on whether anyone actually believes the Fed will hit its goal. Inflation expectations, as measured by the TIPS spread, and the Fed’s past actions suggest that many view the 2 percent goal as more of a ceiling than a target. If that’s the case, perhaps low inflation is what is intended (despite Fed statements to the contrary) and expected—and all is right with the world.

Many economists believe inflation can be too low even if inflation is consistent with expected inflation. To state the matter differently: they believe that both actual and expected inflation can be too low. Some hold this view on the grounds that monetary policy becomes ineffective at the zero-lower bound. They prefer a stable, positive rate of inflation to leave scope for monetary policy should nominal spending contract. Others maintain that there is an optimal rate of inflation—enough to grease the wheels of the labor market or encourage market participants to hold sufficient money balances—where output is at its maximum sustainable level. If inflation deviates from the optimal rate, whatever that rate might be, the economy will produce less than its sustainable potential. Personally, I don’t put much stock in the zero-lower bound argument. (I’m in good company.) And I tend to think the optimal rate of inflation is negative. If I am wrong, though, and inflation is too low at the moment, the Fed should raise its target rate as described above.

2. Productivity growth increases.

As I have suggested in the past, real rates are low at the moment because productivity growth is low. Productivity growth results when entrepreneurs find better ways of producing valuable goods and services. Successful entrepreneurs typically borrow funds in order to finance their new production process and capture the gains from innovation. When productivity growth is high, they take out a lot of loans to finance a lot of activities, driving real interest rates up in the process. When productivity growth is low, however, they are less keen to borrow. Real interest rates are low as a result. It stands to reason, then, that the Fed should raise its target when real rates rise. Holding its target below the market clearing rate—and expanding the monetary base by purchasing assets in accordance with such a target—could generate an unsustainable boom if entrepreneurs are fooled into overproducing. Indeed, some have argued that the Fed’s failure to account for exceptional productivity growth led to the boom of the mid-2000s. I, for one, would prefer not repeating that mistake.

So, there you have it: two scenarios where the Fed should raise its rate—that is, the federal funds rate target. Now let’s dispense with all of this interest rate talk and return to a more straightforward monetary policy rule.

William J. Luther

William J. Luther

William J. Luther is the Director of AIER’s Sound Money Project and an Associate Professor of Economics at Florida Atlantic University. His research focuses primarily on questions of currency acceptance. He has published articles in leading scholarly journals, including Journal of Economic Behavior & Organization, Economic Inquiry, Journal of Institutional Economics, Public Choice, and Quarterly Review of Economics and Finance. His popular writings have appeared in The Economist, Forbes, and U.S. News & World Report. His work has been featured by major media outlets, including NPR, Wall Street Journal, The Guardian, TIME Magazine, National Review, Fox Nation, and VICE News. Luther earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Capital University. He was an AIER Summer Fellowship Program participant in 2010 and 2011.

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