Will the Fed Overshoot?
We’re now in the final week of the 19-year long Greenspan Era. Overall, the period was marked by plenty of strong economic growth, two recessions that were among the mildest on record, and consistently moderate inflation that has gradually trended downward.
But there’s also some fodder for criticism in the record of monetary policy under Greenspan’s leadership. One pattern that we’ve seen is that, during periods of monetary tightening, the Fed has tended to overshoot and tighten too much, necessitating a relatively quick reversal of policy.
The following chart shows the path of the Federal Funds Rate – the market interest rate most directly under the Fed’s control – since 1985. Periods of monetary tightening (higher interest rates) are shaded
red blue, and periods of loosening (lower interest rates) are shaded blue red. The remaining yellow bits are therefore periods when the Fed felt no need to adjust interest rates.
The chart is interesting for several reasons, but let me focus on one here. During each of the past three episodes of monetary tightening, the Fed quickly realized that they had gone too far, and were forced to reduce interest rates after only a short time. In 1989 and 1995 they reversed course on monetary policy after only 4 months, and in 2000 they reversed course after 7 months. Given that changes in the Federal Funds rate are estimated to take 12 to 18 months to have their full impact on the economy, it seems fair to say that in each of these instances Greenspan probably wished that he had stopped raising rates a bit sooner than he actually did.
To be fair to Greenspan, he is certainly not the only central banker to fall victim to the problem of overshooting – such policy mistakes are probably more the rule than the exception among central bankers. But it does add to my worries for the economic outlook in 2006. Is there any reason to think that the Fed won’t overshoot again this year, and find itself soon wishing that they hadn’t raised interest rates quite so much?