Federal Reserve Chairwoman Janet Yellen sided with the late Milton Friedman and against her colleagues Wednesday in one of the major debates within the central bank as it weighs when to raise interest rates.
On the question of whether the Fed should raise rates if it wants to prevent inflation from rising out of control, even if that inflation is not yet apparent in the data, Yellen said at a press conference that it should.
“The notion that monetary policy operates with ‘long and variable lags’ — that statement is due to Miltion Friedman, and it is one of the essential things to understand about monetary policy and it has not fundamentally changed at all,” Yellen said.
“That is why I believe we have to be forward looking, and I’m not in favor of a ‘whites of their eyes’ sort of approach, we need to operate based on forecasts,” she said.
By endorsing the view that the Fed needs to act based on forecasts, Yellen is setting herself apart from at least two of her colleagues on the Fed Board of Governors, both of whom have argued that the central bank should not consider raising rates until there’s actual proof that inflation is going to hit the Fed’s 2 percent target.
Currently, inflation is below 1 percent in the Fed’s preferred measure and has run below target since 2012.
Earlier this month, for example, Governor Daniel Tarullo said in an interview on CNBC that, when it comes to inflation, he is in the “show me” camp. He would “like to see some more tangible evidence of inflation” before deciding to raise rates, he said.
Friedman, the Nobel Prize-winning conservative economist, argued that Fed actions usually only change the real economy on a lag of more than a year. He coined the phrase “long and variable lags,” and once told Congress that monetary policy was like a water tap that you turn on now and only begins running water in six to 16 months.
Tarullo is not the only Fed official not convinced of that logic. In a question-and-answer session following a speech in Chicago earlier this month, Governor Lael Brainard said that, at least as financial markets are concerned, the lags might be short. “My sense is that the responsiveness through financial conditions is relatively rapid now,” she said.
As evidence that monetary policy can affect the economy quickly, Brainard cited what happened to the dollar in 2014: Upon the news that the Fed would begin tightening policy at the same time that major foreign central banks were aiming to start monetary stimulus, the dollar took off, ultimately rising 20 percent.
Yellen did acknowledge that the workings of the economy may have changed at some point since Friedman’s statement. “The structure of the economy changes, things do change,” she said, noting as an example that “we’ve seen inflation respond less to the economy, to movements in the unemployment rate.”
Nevertheless, that allowance from Yellen is not likely to satisfy outside critics who have said that, with inflation low, there is no reason for the Fed to tighten monetary policy until it is certain that the 2 percent target will be hit. One such critic, the Harvard professor Larry Summers, himself once a rumored candidate for Fed chairman, has used the specific “whites of inflation’s eyes” metaphor, a reference to the instructions given to militiamen waiting until the last minute to fire on British soldiers at the Battle of Bunker Hill during the Revolutionary War.
Yellen is far from being alone in judging that the Fed must act based on forecasts. Federal Reserve Bank of San Francisco President John Williams, for instance, has argued that the Fed must raise rates if indicators such as unemployment and output growth suggest that inflation is set to rise to the target.
