The Fed’s muddy monetary road
Monetary policy is always explained in metaphors. Some involve plumbing (“tightening the credit spigot”); some, sailing (“headwinds”); some, cars (“tapping the brakes”). And sometimes old metaphors don’t fit new circumstances.
Enter Andy Levin, a Dartmouth College economics professor and former adviser to Janet Yellen at the Federal Reserve. He offered a new and (as far as I can tell) original elaboration on the old automotive metaphor at an International Monetary Fund conference last week to explain why the Fed should move very cautiously now to raise interest rates.
If the Fed had “perfect foresight,” he said, then setting interest rates is like “driving a familiar car on a flat rural highway with well-maintained pavement, approaching a stop sign that is clearly visible at a considerable distance.”
The car in this story is the economy. The driver is the Fed, and the Fed knows exactly how the car will react when the brakes are tapped. The stop sign is the moment at which unemployment has fallen to the point where wages start to rise, and the Fed should have raised rates so that the economy (to invoke another metaphor) doesn’t overheat and produce unwelcome inflation.
The smart strategy in this case, then, is to “start applying the brakes well in advance and slow down gradually so that the car comes to a smooth stop.”
But those aren’t the circumstances the Fed finds itself in today, Mr. Levin said.
Rather, the Fed is “driving an unfamiliar vehicle up a steep country road that has lots of curves and some muddy conditions, with a stop sign located at the top of the hill that is not yet visible.”
What, then, should the driver do? Don’t drive too fast, of course, but don’t drive too slowly either. “Be careful to preserve momentum and be mindful that the accelerator will be useless if the car gets stuck in the mud,” Mr. Levin advised.
The road ahead is steep, curvy, and muddy. His advice to Chair Yellen: Don’t brake prematurely.
Video: Watch Andy Levin starting at the 1:05 mark in this clip.
Editor’s note: This op-ed originally appeared in the Wall Street Journal on November 8, 2015.