For the Very Serious People of the world, whatever the question, the answer is “inappropriately tight monetary policy.”
And now that worrying about inflation has gone out of style and the panacea canard is played out, the new hotness is to worry that appropriate monetary policy will lead to financial instability.
This is far too ridiculous an idea to take seriously, but unfortunately it’s become clear over the past month that many high-level central bank officials are taking it seriously. And in doing so they’re creating a dangerous level of financial instability. After all, do you know what undermines the stability of financial markets? Unpredictable swings in nominal variables. That’s why clear guidance from central banks is so good. One can debate the merits of the specific quantities involved, but the basic QE 3 framework entailed some admirable clarity. How long would interest rates stay low? At least until the unemployment rate dropped below 6.5 percent or the Core Personal Consumption Expenditures Deflator rose above 2.5 percent. For any market participant, that was like having some nice bumpers in your bowling lane. No guarantees about the macroeconomic future (there never are) but at least some guidelines. Would you be facing a situation in a year in which unemployment is 6.7 percent, inflation is 1.9 percent, and interest rates are rising because the economy’s getting stronger? No. By the power of the Evans Rule that would not be the case.
But today it’s no longer clear that that’s the case. Between FOMC statements, suddenly everyone’s introduced a third completely undefined variable into monetary policy. Fed officials appear to be saying that even if employment and inflation conditions indicate that tighter money would be disastrous, they might do it anyway to avoid “financial instability.” But nobody can be sure exactly what that means. Suddenly the future of policy has become hazier. And that itself undermines stability of financial markets.