Central banks are vested with a tremendous amount of economic power, but there’s no real reason to think that they wield that power wisely. As the U.S. Federal Reserve’s Federal Open Market Committee begins its scheduled meeting, Atlas Network Sound Money Project Fellow Dr. William J. Luther takes a look at the Fed’s targeting of interest rates in a new analysis for Forbes.com, and suggests that its calculations effectively amount to “asking how much force one should apply to the brake while driving blindfolded.” Instead, Luther suggests, the Fed should target nominal income levels.
“Interest rate targeting is fraught with problems,” Luther writes. “In a perfect world, the Fed would set its target equal to the market clearing—or, natural—rate of interest. But the natural rate of interest is not observable and there is little agreement about how high it is at the moment. The Fed is therefore left guessing how high its target should be. This is a problem because if it sets its target too low, open market operations are likely to encourage overproduction. On the other hand, if it sets its target too high, open market operations are likely to encourage underproduction. Errors in both directions make us worse off on net.”
These problems are exacerbated by the inherent instability of interest rates over time, requiring continual adjustments as economic conditions fluctuate. Instead of taking wild stabs in the dark at targets it can’t measure, Luther explains, the Fed should use the stable and observable analytical tools at its disposal.
“A better option would be to target the level of nominal income,” Luther writes. “Under such a rule, the Fed announces in advance that it will conduct open market operations to maintain a path of nominal income, where the level of nominal income along the path grows at a steady rate of, say, 5% per year. If it fails to hit its target in one period, it will have to make up for its error to return to the path in the next period. Unlike the natural rate of interest, the ideal nominal income path (1) is observable and (2) doesn’t change.”
To read Dr. Luther’s piece in its entirety, click here.