Why the Fed can't drive

One of Milton Friedman’s favorite analogies about monetary policy was driving a car. He compared money creation by the Fed to pushing on the gas pedal. On flat ground giving the engine more gas makes the car speed up, so giving the economy more gas should cause it to accelerate as well. But giving the engine more gas by pushing on the pedal may allow the car to slow down when climbing a hill if the engine doesn’t get enough gas to overcome the gravity involved in climbing the hill.

Friedman’s point: interest rates tell us nothing about whether Fed policy is too tight or too loose. Only the speed of economic growth can tell us that. Low interest rates may be too high if the economy is climbing a steep hill, like a recession. On the other hand, high rates may be too low if the economy is speeding up, as it does near the end of an expansion. The grandchildren of Friedman use that analogy to argue for nominal GDP targeting by the Fed instead of price targets. The problem with the Fed’s driving strategy is that it never knows if it is climbing or descending a hill or how fast the economy is growing at the time it makes its policy decisions because of long lag times from policy decision to its impact.