Why might the Fed lift rates?

There is talk that the US Federal Reserve may begin lifting interest rates again in August.

Now this is something that some commentators find unusual (*) (*). However I think it is consistent for Dr Bernanke to slash rates as he has and then turn around to tighten, given the way he views inflation targeting.

Fundamentally, we have seen two very different reactions to a domestic economic slowdown in Europe and the US. In Europe inflation targeting means sticking to your guns on the annual growth in price measure in the economy – and just looking at other economic variables as a secondary concern.

This view of inflation targeting is justifiable given the inherent commitment game that is required to stabilise growth in the general price level in the economy – however, from a welfare maximising point of view it “may” be too black and white.

In the US, Dr Bernanke is also a proponent of inflation targeting (book and a good speech). I get the impression that he enjoys inflation targeting for its ability to anchor inflation expectations – giving the bank the chance to “deviate” from its mandate temporarily to ease economic conditions.

However, this view of inflation targeting has one major catch – the Bank must stay credible! If society believes you are going to deviate, or even might deviate, they will being to price inflation in at a higher rate than is implied by the Bank’s target. As a result, it is vitally important that inflation expectations remain anchored – explaining his concern at recent results.

If the Fed has tried to be too “flexible” with its monetary policy they may cause higher levels of inflation moving forward – which “may” also be suboptimal from a welfare maximising point of view.

As a result, I think the Fed viewed events in the following light. The cutting of rates was to prevent a collapse in the demand side of the economy (where the financial accelerator may cause some type of over-shooting) – which would have been especially costly from a welfare perspective. However, now that the demand side has been given time to optimally re-allocate resources following this shock the Fed is moving back to dealing with inflation – in order to keep credibility as an inflation fighter.

For people with a little bit of game theory knowledge, remember it is possible to have a dynamic equilibrium that involves defection in some states (e.g Green and Porter with tacit collusion) -although the grim trigger equilibrium may be subgame perfect, it is not the only equilibrium, and may be pareto inferior to other equilibria (at least in a Kaldor-Hicks sense 😉 ). As a result, basing monetary policy on the grim trigger strategy is probably a touch extreme 🙂

But it’s all a story of money supply – if we print too much money we have inflation, who cares about expectations!

The Fed doesn’t really target a “level” of the money supply – as doing so is incredibly difficult and inaccurate, and it is hard to know what level of money supply growth is “justifiable” given that economies grow over time. They implicitly define a level of money, given some “level” of money demand, by setting a real interest rate.

Now in this case the money supply is relatively flat in the level of the interest rate, and so growth in the quantity of money in the economy will depend on growth in money demand.

The Fed does not want to restrict money demand that is based on increased production in the economy, but they do want to restrict excess money demand that causes inflation – this stems from inflation expectations.

As a result, what happens to inflation expectations is the key to inflationary outcomes. This is why I applaud the Fed for placing such concern on rising inflation expectations – I only hope the RBA and RBNZ are willing to do the same thing.