What target should the Fed be shooting at?

The conventional wisdom on interest rates may be wrong

John H. Cochrane

The Grumpy Economist

John H. Cochrane | May 16, 2017

Sections Economics

Collections Monetary Policy

Underneath the quarterly hurly-burly—will the US Federal Reserve raise or lower rates a quarter percent? What will the Fed say about the economy?—a deeper discussion is brewing. Where are interest rates headed eventually? What should the Fed’s long-term interest-rate target be? 

The traditional view is that the interest-rates glide path should aim at 4 percent: 2 percent real interest plus 2 percent inflation. But 4 percent is not written in stone, and many people inside and outside the Fed are rethinking this conventional wisdom.

3 percent?

One big subject of debate right now is whether the long-term “natural” real rate of interest—r*, or “r-star” in econ speak—has declined below 2 percent. Over the long run, the Fed cannot control the real rate of interest; that comes from how much people want to save and what opportunities there are for investment, i.e. the marginal product of capital. So, if the real rate of interest is now permanently lower, say 1 percent, one might argue that the glide path should aim for a 3 percent long-term interest rate—1 percent real interest plus the usual 2 percent inflation target—not 4 percent. 

Fed Chair Janet Yellen recently came to Stanford and gave a very interesting speech in which she talked in part about a lower r*, and seemed to be heading to something like this view. Of course, cynics will say that it’s just the latest excuse not to raise rates. But this is a serious argument that should be considered on its merits.

0 percent?

So is a glide path toward 3 percent the answer? Maybe not. How about zero?

Long ago, Milton Friedman explained the “optimal quantity of money,” which is really the optimal interest rate. It is zero. (Or “permazero,” in St. Louis Fed President Jim Bullard’s colorful terminology.) At interest rates above zero, people hold less cash and spend time and effort collecting bills early, paying them late, and so on. This is all a waste of time from a social point of view. Also, taxes on rate of return are a bad idea. With all rates of return that much lower, the tax distortion is that much lower. For example, with 0 percent interest rates, and correspondingly lower inflation, inflation-induced capital-gains taxes vanish.

So maybe the glide path should be to a 0 percent interest rate, not 3 percent. If the natural real rate is 1 percent, then the Fed should instead moderate the inflation target, to -1 percent. 

In this line of thinking, the long-term interest rate is what counts directly. Rather than start with a natural rate, add an inflation target, and deduce the long-term interest rate, we start with the desirable long-term interest rate, subtract the natural real rate, and deduce long-term inflation. And indeed, it becomes much less important for the Fed to divine what the “natural” rate is, as a larger natural rate will automatically be reflected in persistently low inflation. 

4 percent?

Why not permazero interest rates? The primary reason often given is that interest rates gliding toward a zero long-term target cannot go substantially below zero, at least without banning cash and undergoing many other gyrations of our monetary and financial system. So if the interest rate is near zero, the Fed does not have “headroom” to stimulate the economy in a recession. I don’t necessarily agree that this is so important, but let’s go with it for a moment. 

Another argument against a zero long-term interest-rate target is conventional Keynesian policy analysts’ concern about a “deflation spiral” if the Fed can’t lower rates. Deflation breaks out, the Fed cannot lower rates, real interest rates rise, this lowers aggregate demand, and through the Phillips curve, more deflation breaks out, in an explosive downward spiral. I’m not convinced this is a problem either, as recent experience at the zero bound didn’t include this spiral and New Keynesian models don’t spiral, but we’re here today to flesh out the arguments, not to adjudicate them.

Still, both arguments for headroom above zero seem to imply a direct nominal-interest-rate target, not the sum of inflation plus the real rate of interest. If the Fed needs 4 percentage points of headroom, consisting of 2 percent real interest plus 2 percent inflation, it needs 4 percentage points of headroom, consisting of 1 percent real interest plus 3 percent inflation, no?

So, from either the optimal quantity of money or the zero-bound-headroom argument, it does not follow obviously that the interest-rate target should move up and down with the natural rate.

Permatwo? 

The question is, then, why is there a direct role for the inflation target? Why do we have to start with 2 percent inflation and then add the long-term real rate to deduce the nominal-rate glide path, rather than think directly about the long-term interest rate?

I think the answer is that prices and wages are felt to be sticky, especially downward. This is the second argument against the Friedman zero-interest-rate rule: its steady deflation is said to require people to change prices and wages downward. This is said to cause disruption.

OK (maybe), no Friedman-optimal deflation. But why then 2 percent rather than 0 percent inflation?

Quality-induced inflation

One argument for 2 percent inflation is that inflation is overstated due to quality improvements. Two percent is really 0 percent.

For example, suppose the iPhone 6 turns into the iPhone 7 and costs $100 more. How much of that is inflation, and how much of it is that the iPhone 7 is $100 better? Maybe the iPhone 7 is $200 better, and we are actually seeing $100 iPhone deflation. 

The Bureau of Labor Statistics makes heroic efforts to adjust for this sort of thing, but the consensus seems to be that inflation is still overstated by something like 1–2 percent. (The Senate Finance Committee’s Boskin Commission Report, for instance, suggested that the bureau’s Consumer Price Index was overstated by about 1 percent, as of 1996. University of Rochester’s Mark Bils argued in a 2009 paper that it’s a good deal more, though Bils’s analysis was limited to consumer durables, where quality has been increasing quickly. Recent work from Philippe Aghion, Antonin Bergeaud, Timo Boppart, Peter J. Klenow, and Huiyu Li suggests there is another 0.5–1 percent overstatement because of goods that just disappear from the CPI.)

This is good news. Nominal GDP growth equals real GDP growth plus inflation. Nominal GDP growth is relatively well measured. If inflation is 1 percent overstated, then real growth is 1 percent understated.

It also means our real interest rates are mismeasured. If 2 percent inflation is really 0 percent inflation, then 1 percent interest rates are really +1 percent real rates, not -1 percent real rates.

Back to monetary policy. Suppose that 2 percent inflation is really 0 percent inflation due to quality effects. Does that mean we should have a 2 percent long-term inflation-rate target? 

I don’t think so. Again, the motivation for a positive inflation target is that there is some economic damage if people have to lower prices and wages. But during quality improvements of new goods, nobody has to lower any prices. They are new goods! No existing good has to have lower prices. In fact, actual sticker prices rise. 

There is a deeper point here. Not all uses of inflation measures are equal. One purpose of the CPI is to compare living standards over time. For that purpose, quality adjustments are really important. Another purpose of the CPI is to determine if people have to undergo whatever pain is associated with lowering prices. For that purpose, quality adjustments are irrelevant.

Interest rates crashed in a month in 2008 because real rates crashed. The Fed couldn’t have kept rates at 6 percent if it wanted to.

On both prices and wages, we also should remember the huge churn. Lots of prices and wages go up, lots go down. The individual is not the average. Changing the average inflation one or two percentage points doesn’t make much difference in how many prices or wages actually have to go down. 

In sum, the argument that quality improvements mean 2 percent inflation is really 0 percent inflation does not imply that therefore the inflation target should be 2 percent because otherwise people have to lower prices. Standard-of-living inflation is not the right measure for costs-of-price-stickiness inflation. In price-stickiness logic, the Fed should be looking at a CPI measure with no quality adjustments at all! (At least in this simplistic analysis.)

So the argument for a separate inflation target much above zero seems weak to me. We’re back to the Friedman rule versus headroom, which argues for a direct nominal-interest-rate target. Since I’m not much of a fan of headroom or activist monetary policy, involving large changes in interest rates to direct the macroeconomy from on high, I lean toward lower values.

Leaving aside price stickiness, I’m still sympathetic to a price-level target, rather than any inflation target, on expectations grounds. If the quality-adjusted CPI is the same forever, then we have a CPI standard, the value of a dollar is always constant, and long-term uncertainty decreases. We don’t shorten the meter 2 percent every year. For this purpose, we do want the quality-adjusted CPI, and for this purpose the inflation target is primary. An interest-rate target would have to rise and fall with r*.

Real-rate variation

There really is no reason that the “natural” real rate only varies slowly over time. Interest rates crashed in a month in 2008 because real rates crashed—everyone wanted to save, and nobody wanted to invest. The Fed couldn’t have kept rates at 6 percent if it wanted to.

So, the procedures used to measure r*, like those used to measure potential output, are a bit suspect. They amount to taking long moving averages and assuming that supply shocks only act slowly over time. 

Typical optimal-monetary-policy discussions use a Taylor rule,

funds rate = r* + 1.5 x (inflation - target) + 0.5 x (output gap) + deviation

and recommend short-term deviations from the Taylor rule if there are supply shocks. Well, short-term deviations are the same thing as short-term movements in r*

There’s more than the conventional answer

As often in policy, we argue too much about the external causes, as if the policy consequences were obvious, and not enough about the logic tying causes to policy. There may or may not have been a decline in r*. But it does not follow that the glide-path nominal rate should be r* plus a 2 percent inflation target. Maybe the glide path should be a 0 percent nominal rate or a 4 percent nominal rate independent of r*. There are plenty of mechanisms and trade-offs worthy of thinking hard about. 

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and distinguished senior fellow at Chicago Booth. This essay is adapted from a post on his blog, The Grumpy Economist.