Frankly speaking I don't feel like commenting much on the FOMC's decision on Wesnesday to keep the Fed Funds target unchanged - it was as expected, but sadly, it is very clear that the Fed has not given up the 1970s-style focus on the Phillips curve and on the US labour market rather than focusing on monetary and market indicators. That is just plain depressing.
Anyway, I would rather focus on the policy framework rather than on today's decision, because at the core of why the Fed consistently seems to fail on monetary policy is the weaknesses in the monetary policy framework.
Here, I will suggest three simple changes in the Fed's policy framework, which I believe would dramatically improve the quality of US monetary policy:
- Introduce a 4% Nominal GDP level target. The focus should be on the expected NGDP level in 18-24 months. A 4% NGDP target would, over the medium term, also ensure price stability and "maximum employment". No other targets are needed.
- The Fed should give up doing forecasting on its own. Instead, three sources for NGDP expectations should be used: 1) The Fed should set up a prediction market for NGDP in 12 and 24 months; 2) Survey of professional forecasters' NGDP expectations; 3) The Fed should set up financial market-based models for NGDP expectations.
- Give up interest rate targeting (the horrible "dot" forceasts from the FOMC members) and, instead, use the money base as the monetary policy framework. At each FOMC meeting, the FOMC should announce the permanent yearly growth rate of the money base. The money base growth rate should be set to hit the Fed's 4% NGDP level target. Interest rates should be completely market-determined. The Fed should commit itself to only referring to the expected level for NGDP in 18-24 months compared to the targeted level when announcing the money base growth rate. Nothing else should be important for monetary policy.
This would have a number of positive consequences.
First, the policy would be completely rule-based, contrary to today's discretion policy.
Second, the policy would be completely transparent, and in reality, the market would be doing most of the lifting in terms of implementing the NGDP target.
Third, there would never be a Zero Lower Bound problem. With money base control, monetary policy can always be eased even if interest rates are at the ZLB.
Fourth, all the silly talk about bubbles, moral hazard and irrational investors in the stock markets would come to an end. Please stop all the macroprudential nonsense right now. The Fed will never ever be able to spot bubbles and shouldn't try to do it.
Fifth, the Fed would stop reacting to supply shocks (positive and negative), and finally, sixth, the FOMC could essentially be replaced by a computer as long ago suggested by Milton Friedman.
Will this ever happen? No, there is of course no chance that this will ever happen, because that would mean the FOMC members would have to give up the belief in their own super-human abilities, and the FOMC would have to give up its discretionary powers. So, I guess we might as well prepare ourselves for a US recession later this year. It seems incredible, but right now it seems like Janet Yellen's Fed has repeated the Mistakes of '37.
P.S.: What I here have suggested is essentially a forward-looking McCallum rule.