Cato Journal: Inflation Targets, Behavioral Economics, and Interest on Reserves

Federal Reserve, Cato Journal, The Fed, behavioral economics, inflation targeting, zero lower bound, balance sheet, normalization
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Silhouette archery shoots a bow at the target.The fall 2016 issue of the Cato Journal is now available. Along with articles on free speech, climate change, and the peculiar business of politics, the latest edition offers a full line up on pressing issues in the current discourse on monetary policy. Among them are pieces critiquing calls to raise the Fed's inflation target, the Fed's interest on reserves policy, and the Fed's decision-making capacity.

Don’t Raise the Inflation Target

William T. Gavin, a former vice president and economist at the St. Louis Fed, argues against proposals to raise the inflation target. Proponents of such a plan say that raising the target would give the Federal Reserve more room to cut interest rates the next time we run into a financial crisis or recession. But Gavin suggests this idea is based on faulty logic.

For one thing, Gavin writes, the Fed would have hit the zero lower bound in 2008 whatever the inflation target was at the time. Reaching zero has not been a conscious choice, but rather an inevitable result of emergency lending programs that flooded the market with bank reserves. And the Fed is likely to keep hitting zero, says Gavin, not because the inflation target is too low, but rather because monetary policymakers are too aggressive in cutting rates, and too cautious in raising them — this means rates have a downward bias over time.

What’s more, Gavin argues that low interest rates don’t necessarily boost the economy, due to their effect on work, saving, and investment. At the same time, low interest rates can encourage the kind of risk-taking that was behind the 2008 financial crisis in the first place.

Finally, Gavin believes that raising the inflation target would undermine its usefulness as a nominal anchor of market expectations. Higher inflation is costly too, both because of its deleterious impact on economic calculation, and because its interaction with the tax code has a growth-sapping effect on investment.

The Cognitive Biases of Central Bankers

Elsewhere, Cato’s Mark Calabria notes that 95% of the behavioral economics literature overlooks the cognitive biases of policymakers. He seeks to redress that balance with a preliminary analysis of the potential cognitive failures in Federal Reserve policymaking. These include availability bias, whereby certain historical episodes (like the Great Depression) dominate discussions of policy, even when the present situation is quite different; representativeness bias, according to which policymakers are inclined to make sweeping assumptions based on limited data; and status quo bias, which can make policymakers too slow to respond to changed circumstances. Calabria also points to loss aversion and overconfidence among central bankers.

There are ways to overcome cognitive biases, Calabria points out. However, the two methods the Fed would likely claim to be employing — expertise and committee-based decisionmaking — both have limitations. Expertise only helps when you operate in a regular, predictable environment, and have the opportunity to learn via repeated practice — neither of those conditions is met in the case of the Fed. Decision-making by committee, meanwhile, only helps to overcome cognitive biases when there is sufficient diversity of ideas among the committee members. It is hard to argue the FOMC meets that particular criteria.

This leaves two alternative ways to address monetary policymakers’ cognitive biases: following a rule, and subjecting decisions to adversarial review. I’ll leave readers to guess where Mark stands on those issues!

Phasing Out Interest on Reserves

Finally, leading monetary economist John Taylor reviews the massive expansion over the last decade of the Federal Reserve’s balance sheet. Quantitative easing, he points out, made the Fed’s paying interest on reserves inevitable — without it, the Fed would have no way to influence the federal funds rate, which it uses to implement its policy decisions. In the short term, Taylor writes, the Fed has no choice but to use interest on reserves as it seeks to normalize monetary policy by raising interest rates.

In the longer term, however, Taylor believes that the size and composition of the Fed’s balance sheet should be consistent with the federal funds rate being market-determined, rather than administratively determined by the Fed through interest on reserves. This means the Fed must reduce its securities holdings over time. To do otherwise would leave the Fed with too much power over credit allocation, as well as a quasi-fiscal role better left to Congress. The Fed, Taylor concludes, should get back to being a limited purpose monetary institution, setting its policy rate in a rule-like fashion.

You can find the latest issue of the Cato Journal, as well as archives stretching back to 1981, at