I have been arguing for some time that the Fed’s interest rate target is exceptionally low and that upward adjustment is needed.7 I have based that in part on the behavior of benchmarks that capture the historical behavior of interest rates — that is, how policy rates respond to inflation and employment — during times when monetary policy has been relatively effective. These benchmarks, often referred to as “policy rules,” come in slightly different formulations and are useful for assessing the stance of monetary policy. Currently, almost all of these benchmarks recommend higher interest rates, in most cases substantially higher rates. Some have made the case for versions whose current recommendations lie at the lower end of the range of plausible alternatives and thus align with the current low level of our policy rates.8 That case is not without merit, but there are risks associated with placing too much weight on any one estimate. Taking the range of plausible alternatives into account, my view is that, with unemployment at or below levels corresponding to maximum sustainable employment and with inflation very close to our announced target of 2 percent, significantly higher rates are warranted.
Historical experience strongly suggests that significant deviation from these benchmarks can increase the risk of adverse outcomes. In particular, delaying interest rate increases when unemployment falls below levels corresponding to full or maximum employment can result in an unanticipated rise in inflation pressures that necessitates relatively sharp upward adjustments in rates. Such rapid adjustments can be hard to calibrate, and they heighten the risk of overdoing it and sending the economy into an unnecessary recession.
At the present time, I am skeptical of justifications for the large and growing departure of current policy from the policy rule recommendations. My own view, as I’ve said, is that the magnitude of the gap suggests that rates need to rise more briskly than markets now seem to expect. And the elevated uncertainty now surrounding fiscal policy, particularly the potential for substantial fiscal stimulus, suggests that our next increase should come sooner rather than later in order to reduce the risks associated with having to raise rates more rapidly later on. Such an approach would maximize our chance of continuing to benefit from price stability and healthy employment growth.