Markets heaved a sigh of relief of Tuesday, when Federal Reserve Chair Janet Yellen told the Senate that interest rate hikes probably wouldn't come until at least the latter part of 2015.
At least, that's what everyone decided Yellen said. Her actual remarks were a study in vagueness. The new market expectation of a rate hike in late fall is a guess, as was the previous expectation of a hike mid-year.
This is a problem. Thanks to its ability to print money and push interest rates in one direction or another, the Fed wields enormous power over how friendly the national economic environment is to growth. Yet in trying to figure out how the Fed intends to use this enormous power, every other actor in the economy is reduced to poring over cryptic statements from Fed officials, parsing words like "patience" and "appropriate" for clues.
Let's pause for a moment and acknowledge that this is a completely insane way to run monetary policy. And to fix it, the best thing Congress can do is just amend the Fed's mandate and give it a hard numerical target.
Consider that "forward guidance" is one of the Fed's key responsibilities. Yellen and Co. have to tell markets, firms, and everyone else in the economy what they're going to do, then make sure everyone believes them over time, even when what they're going to do is a radical and ambitious response to extremely unusual events.
One of the big goals of quantitative easing, for example, was to raise the markets' expectation of what inflation would be years from now, because higher future inflation implies higher future wage and job growth. But while there's circumstantial evidence quantitative easing put a floor under the American economy, it's hard to see any sign that, after three rounds, it had any lasting effect on inflation expectations.
A big reason for this is that effective forward guidance is impossible as currently run. As Mike Konczal once explained, under these circumstances, any stray comment by a Fed official, or a disagreement within its ranks, can wreck the effort:
Aggressive monetary policy begins to expand the economy, or at least gives the impression the economy is expanding. Central bankers argue that this means that they can pull back quicker than expected. (They don't pull back; they just say they will.) The expectations for future policy then collapse, because central bankers signal that it will end too soon. The economy then weakens, going back to where it started. [Mike Konczal]
Now look at Yellen's comments from Tuesday. "A high degree of policy accommodation remains appropriate," Yellen declared, saying the Federal Open Market Committee — the Fed body that decides monetary policy — has judged "it can be patient." It will determine policy on "a meeting-to-meeting basis," and doesn't think an increase will be needed "for at least the next couple of FOMC meetings." The Hill described the markets as "trying to discern" the Fed's intentions; CNBC rightly referred to it all as "speculation"; and Foreign Policy literally called Yellen's remarks "code to investors."
Imagine the Fed is a 10-foot-tall, war-hammer-wielding giant in the middle of a crowded room, suffering from multiple personality disorder. And everyone else is nervously watching for which personality is blurting out what at a given moment, in the hopes it will signal whether this giant is about to begin laying about the place with its mallet.
That's basically how forward guidance currently works in America.
A big reason why it works this way is that Congress has given the Fed no clear numerical target to hit. The language of the mandate just says the Fed is to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."
In practice, the Fed has settled on 2 percent as its preferred annual rate of inflation. Though whether this functions more as a target or a ceiling is anyone's guess, as is how the Fed balances that against "maximizing employment." Historically, the Fed has done a pretty good job hitting 2 percent inflation, but has done an absolutely terrible job of keeping unemployment low.
So one thing Congress could do is amend the mandate to give the Fed a hard inflation rate to hit. Research suggests 4 percent would be a good target. Even better would be price-level targeting. In that case, you don't target a rate of inflation, you target an actual level for prices each year. (Or over whatever time period you're measuring.) The levels targeted each year would assume a rate, but if we missed a level target one year, the Fed would be free to let the inflation rate rise or fall to get back on course for the next year.
Congress' mandate isn't wrong to include maximizing employment as a goal. So the best approach would arguably be nominal gross domestic product (NGDP)-level targeting. That would, again, target a level each year rather than a rate. But the level would be measured in NGDP, which builds in both inflation and real economic growth.
The point is, in a world where the Fed was required by law to hit a hard numerical target, everyone would know what precise, objectively measurable result the institution was obligated to reach. How it would do that would still involve some degree of unpredictability. But the Fed's toolkit is limited. So if everyone knew the Fed's macroeconomic target, and what that measure was at in any given point in time, it just would require some simple math to get a pretty clear idea of how the Fed was going to get from point A to point B.
Fed chairs' appearances before Congress would no longer be about what they're going to do, but about why they haven't hit their targets. They would no longer have to communicate in "code."
Wouldn't that be nice?