Radical Fed Doves Actually Took a Middle Path on Interest Rates
Policy + Politics

Radical Fed Doves Actually Took a Middle Path on Interest Rates

There is a good chance that today, Janet Yellen and the members of the Federal Open Market Committee will take a small, tentative step toward raising interest rates from their current levels just above zero. That is not to say rates are going up any time soon, but the FOMC, which sets monetary policy for the central bank, is believed to be at least considering a change in the way it talks about future interest rate increases. 

The hallmark of Yellen’s first year at the helm of the central bank has been a continuation of the “dovish” policies of her predecessor, Ben Bernanke. In monetary policy-speak, doves are willing to keep interest rates low, risking higher inflation, in order to create jobs and stimulate economic growth. Hawks, by contrast, believe the danger of high inflation is significant enough that the Fed should preemptively raise rates to avoid it. 

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Assuming the economy continues on its current path, the ongoing recovery will likely be viewed by most as the triumph of the doves. First Bernanke and then Yellen resisted warnings about inflation and kept rates as low as possible for what was once an unthinkably long time. They took radically new steps to pump money into the system. The road back was long and the going slow, but the economy recovered, didn’t overheat, and seems to be gradually finding its way back to something like full employment. 

In the popular mind, the characterization of Bernanke and Yellen on one side of the debate and inflation hawks on the other is common because it’s easy to understand. But people deeply engaged in the monetary policy debates recognize that, for as dramatic as the Fed action has been, what the central bank actually did was find a tenuous middle ground between the hawks on the FOMC and influential monetary policy experts who were actually far more dovish than either Fed chair. 

One of those experts is Columbia Professor Michael Woodford. In 2012, Woodford, a preeminent monetary policy theorist, delivered a paper at the Federal Reserve’s annual gathering at Jackson Hole, WY. The paper built on research he and colleague Gauti Eggertsson had done a decade before exploring how monetary policy could be made to work once interest rates were driven to near zero. 

In essence, it was a call for the FOMC to rethink dramatically its forward guidance and to shift its focus from inflation to nominal GDP. 

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Where the Fed was focused on “quantitative easing” — buying up trillions in Treasury bonds and mortgage-backed securities to pump money into the economy and drive interest rates even lower — Woodson’s said there was a more effective path the Fed could take. The core idea was that central bankers could exert more influence over interest rates by convincing the market they would be willing to keep interest rates low for long enough to let inflation creep above their official 2 percent target. “Overshooting” in that way, Woodford’s paper suggested, would do more than buying up bonds. 

The paper was a direct challenge to Fed leadership, and received a lot of attention in the economic community. Since then, numerous figures in the economics community have spoken in favor of “overshooting” on inflation. In February, Federal Reserve Bank of Chicago President Charles Evans said the Fed needed to be explicitly willing to drive inflation higher than its target rate. And as recently as last week, Stanford Professor and Hoover Institution Senior Fellow Robert Hall spoke in favor of potentially overshooting the inflation target at a conference at the Brookings Institution. 

Woodford, one of the fathers of the idea, says that most of the expected benefit of a promise to overshoot came not from the action itself, but from the market participants’ expectations based on the Fed officials’ guidance. 

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“I believe that there would have been important gains from such an advance commitment, had it been made back in 2010 or even in 2012,” Woodson said. “But the gains come from the effects of people's being able to anticipate the policy overshoot before it occurs.” 

Now it may be too late, he says. “There would be little gain from trying to create such an anticipation now, if you did not already commit yourself to it earlier, because now we are nearing the end of the period in which the Fed has been unable to ease financial conditions as much as it wanted to through conventional interest-rate policy.” 

In short, the FOMC had already bet that bringing inflation back to 2 percent, and at the current pace, will be sufficient to keep the economy on an upward path. 

“I think it's very unlikely that they will ‘decide to overshoot,’ in the sense of announcing an intention to aim for such a path,” Woodford said. “I think they believed that raising the inflation rate up to the target level from below, without any overshooting, would already require interest rates to remain low for quite a while; and so they thought that committing to do that (but not to overshoot) had already involved promising to keep rates low for some time, and this was as aggressive a commitment as they felt it was wise to make.” 

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