Fed is right on rates – just not right enough

One of the officials responsible for setting interest rates at the U.S. Federal Reserve, St. Louis Fed President James Bullard, has signaled a big change: Previously an outspoken advocate for raising rates aggressively, he now thinks the economy is so weak that a mere quarter-percentage-point increase would be enough for the foreseeable future.

Although his re-evaluation of the economic situation makes sense, I think his prescription should be more ambitious.

Bullard’s rationale focuses on productivity, the amount of goods and services that people produce for each hour worked. Productivity has grown slowly over the past decade, providing much less of a boost to overall economic growth than it has historically. The St. Louis Fed has come to believe that this represents a new regime, in which potential growth – and the appropriate interest-rate target – are lower than they otherwise would be. Depressing as this outlook may be, it’s hard to refute given the U.S. economy’s poor recent performance.

The question, then, is why Bullard wouldn’t argue for lowering rates to support faster growth. His answer: the Fed has already reached its target of 2-percent annual inflation, so further stimulus would risk overshooting that goal.

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His justification has two flaws. First, Bullard uses a somewhat obscure measure of inflation developed by the Dallas Fed, rather than the Fed’s preferred measure, which is well below 2 percent and is expected to remain there for the next two to three years. Second, the risk of excess inflation is relatively manageable: The Fed can readily address it by raising interest rates. What’s really troubling is the possibility that, say, global financial instability will require the Fed to rescue the U.S. economy at a time when its capacity to lower rates is severely limited.

Given this asymmetric downside risk, the Fed should act now to ensure that the economy is as healthy and resilient as possible. That requires cutting, not raising, its rate target.

The shift in Bullard’s outlook sends an important message to investors and the public: The Fed is constantly reassessing the state of the economy, and can thus change its plans for interest rates sharply. This means investors should put less emphasis on the outlook for interest rates, and focus instead on whether the Fed is making fast enough progress toward its economic goals.

Narayana Kocherlakota is a Bloomberg View columnist and the Lionel W. McKenzie professor of economics at the University of Rochester. He served as president of the Federal Reserve Bank of Minneapolis from 2009 through 2015.