Can overshooting also cause recession?

In recent years, the Fed predicted inflation would be below the target. For a while, inflation remained below 2%. It has risen above 2% this year, and it looks like it will stay around for a while. Actually, this situation itself is not a problem. Last summer, the Fed switched to “average inflation targeting,” which includes offsetting periods below 2% with periods above 2%(and vice versa).

As I wrote earlier, I am not worried about inflation staying in this situation for the time being. However, I believe there is another reason for us to worry. The danger is that the Fed is unwilling and conservative to adjust its policy instruments according to changing economic conditions.

One might say, “The Fed will be fine.” Don’t mistake; I think Powell did and does a pretty good job. Nevertheless, what we have witnessed before shows reason to worry. George Selgin here argues that the increase in interest rates in 2015 was not related to the target, but because very low interest rates were not desired for “uncertain and difficult to describe” reasons. If you start to think that the policy tools are the policy goal itself, then you will go astray.

Today we may be experiencing an opposite scenario. While it may be too early to say something, the Fed may be treating low rates as the goal itself, not as a means to reach the inflation target. So I believe there is a possibility that the Fed may hesitate to raise interest rates, even if economic conditions call for it.

When the ECB was established, it adopted inflation targeting to control(and reducing) inflation. However, the process resulted in the ECB trying to increase inflation due to the problems created by inflation targeting. Likewise, AIT may result in the Fed trying to reduce inflation at the end of the process(say to zero bound).

5-year TIPS spreads increased to 2.6-7%. This means PCE inflation of about 2.3-4% in 5 years, and that’s enough to offset:

Many people know and understand that tight monetary policies can create business cycles, but much less know and understand that expansionary monetary policies are equally likely to create business cycles(Austrians like Hayek got it). The optimal rate is roughly 4% growth of NGDP each year. No more, no less.

Right now, I’m not worried about the overheating of the economy, but certainly not because I don’t think it’s bad. The overheating of the economy is the footsteps of a major crash and will likely create a recession soon after. So don’t listen to people who were already discredited in 1968, that is, claiming that overheating would not be so bad as it would help workers find jobs. The real risk of an overly expansionary monetary policy is that it will later cause a recession.

If the TIPS spread reaches 3%, it will be an obvious sign that the Fed is falling behind the curve and will likely overheat. Another sign could be a sharp increase in long-term T-bond yields. Fortunately, we are not at this point now. The bond yields are pretty low, so we don’t have to worry for now.

The Fed should repeat its 2% AIT commitment regardless of whether this commitment is easier or tighter money. Moreover, they should say that your interest rate target will depend on the data, and if necessary, they can make significant changes in the fund target to keep the average inflation at 2%. And they must strive to internalize this perception. Because as long as people do not internalize this perception, it can cause bigger problems:

Notify of
Inline Feedbacks
View all comments