(Bloomberg View) -- When asked why they’re gradually removing monetary stimulus even though inflation remains too low, Federal Reserve officials tend to offer the same refrain: If they don’t start moving now, they could eventually be forced to raise rates more sharply when the economy overheats. This fear of raising rates rapidly is a relatively recent phenomenon -- and it’s a key drag on the overall U.S. economy.
The Fed hasn’t always been so afraid to raise rates sharply. Over the course of nine monetary policy meetings, from February 1994 to February 1995, the central bank increased its short-term interest-rate target by a half percentage point at three meetings and by 0.75 percentage point at a fourth. Since then, however, it has raised rates by more than a quarter percentage point only once (in 2000), opting to act as gradually and predictably as possible.
This systematic avoidance of big interest-rate increases might sound like a dovish, growth-friendly regime. In fact, it’s the opposite. To understand why, imagine driving a car in which, for some reason, you’ve decided to never use the brakes. Naturally, you’ll speed up more if you happen to hit a downhill patch. To compensate for that risk, you’ll drive more slowly all the time. It’ll take you longer -- maybe much longer -- to get where you’re going.
This is exactly the Fed’s situation. It has decided that it will never hit the brakes by raising rates quickly. So it has to apply stimulus very cautiously, to be sure that the economy never gets close to overheating. The result is that inflation has been below target and economic output has been below potential for nearly all of the past 23 years.
Why did the Fed switch to this no-brakes regime? It happened after 1994, which is an important year in Wall Street history. In an event still remembered as the Great Bond Massacre, prices of long-term bonds fell sharply, leading to hundreds of billions of dollars in losses. Many blamed the Fed’s moves to raise short-term interest rates. The central bank’s desire to avoid a repeat of this episode has since made it extremely reluctant to raise rates sharply.
Yet most Americans have never heard of the Great Bond Massacre -- because it had essentially no effect on the broader U.S. economy. So the Fed’s no-brakes policy is designed primarily to protect Wall Street. Meanwhile, it is inflicting a permanent drag on Main Street.
To be clear, I’m not suggesting that the Fed should raise interest rates sharply right now -- on the contrary, I believe more stimulus is in order. In the longer run, though, the Fed should abandon its quarter-percentage-point limit on interest-rate increases. By doing so, it could safely keep rates lower for longer now, and so continue to provide needed support to both employment and prices.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Narayana Kocherlakota is a Bloomberg View columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
To contact the author of this story: Narayana Kocherlakota at nkocherlako1@bloomberg.net.
To contact the editor responsible for this story: Mark Whitehouse at mwhitehouse1@bloomberg.net.
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