Economic developments over the past twenty years have taught--or ought to have taught--the U.S. Federal Reserve four lessons. Yet the Fed's current policy posture raises the question of whether it has internalized any of them. The first lesson is that, at least as long as the current interest rate configuration is sustained, the proper inflation target for the Fed should be 4 percent per year, rather than 2 percent. A higher target is essential in order to have enough room to make the cuts in short-term safe nominal interest rates of five percentage points or more that are usually called for to cushion the effects of a recession when it hits the economy.
The Fed protests that to change its inflation target even once would erode the credibility of its commitment to ensuring price stability. But the Fed can pay now or it can pay later. After all, what good is credibility today when it means sticking tenaciously to a policy that deprives you of the ability to do your job properly tomorrow?
The second lesson is that the two slope coefficients in the algebraic equation that is the Phillips curve--the link between expected inflation and current inflation, and the responsiveness of future inflation to current unemployment--are both much smaller than they were back in the 1970s or even in the 1980s. Then-Fed Chair Alan Greenspan recognized this in the 1990s. He rightly judged that pushing for faster growth and lower unemployment was not taking excessive risks, but rather harvesting low-hanging fruit. The current Fed appears to have a different view.
The third lesson is that yield-curve inversion in the bond market is not just a sign that the market thinks that monetary policy is too tight; it is a sign that monetary policy really is too tight. The people who bid up the prices of long-term U.S. Treasury bills in anticipation of interest rate cuts when the Fed overshoots and triggers a recession are the same people who are now on tenterhooks wondering when to start cutting back on investment plans because a recession will soon produce overcapacity.
The Fed today has a "habitat theory" about why this time is different--that is, why the preferences of investors for particular maturity lengths imply that a yield curve inversion would not mean what it has always meant. But 2006, just before the financial crisis hit, was supposed to be different, too. (And there were plenty of times before then that were supposed to be different, too.) History suggests...