I was alerted by Matt O Brien on Twitter that some [see, for example this NY Times op-ed] are arguing that the Fed and other central banks, who had prefigured an imminent first hike in rates in their speeches, should follow through regardless and raise rates, ‘to show some spine’, else run the risk of losing inflation-fighting credibility.
This argument ought to have no foundation. But unfortunately it has.
In an ideal world, the central bank would be sufficiently transparent about its objectives, and its interest rate plans, and how the latter are contingent on the evolution of data, that there would be no need, if bad economic news interferes, to follow through on an interest rate rise that was consistent with the old data, for the sake of ‘showing spine’. Indeed, in that world, raising rates would constitute an unwelcome policy surprise, a departure from the agreed contingent plan. Those who had grasped the old plan would set about working out what the new plan was, and for a while, the economy would suffer as a result of the increased monetary policy uncertainty.
The element of truth in the argument is that there is not this sufficient degree of transparency. We don’t know precisely how the FOMC or the MPC, for example, trade-off their goals of stabilising inflation and real activity. And we don’t know how those objectives translate into operational policy rules, nor how those rules, given a view about how the economy plays out over the future, translate into a properly state-contingent plan for interest rates. This opacity allows the view to take hold that the Fed needed to and was going to raise rates come what may. And that any sign that they don’t, following a stock-market correction, is a sign that they have been taken over by the low interest rate lobby.
Despite this kernel of truth, I’m confident that policymakers won’t put much weight on this concern, behaving instead as they do in a properly contingent fashion, and will put back rate rises if necessary. But they would be advised to try harder to communicate what they do, their plans for achieving it, and how that translates into interest rate trajectories from quarter to quarter. This won’t and shouldn’t insulate the Fed and other central banks entirely from criticism. But it would raise the level of debate from ‘you should be raising rates, cowards!’ to: ‘oh, those are your objectives, are they, well I don’t like that!’ or ‘if that’s what you are trying to achieve, you have a funny way of going about it!’.