Summers on monetary policy
Many commenters have asked me for my views on a recent WaPo article by Larry Summers. (And by the way, doesn’t anyone proofread at WaPo? They have the wrong inflation expectations graph, showing the Michigan survey instead of TIPS spreads.)
Here’s how Summers begins:
As the Federal Reserve meets today and tomorrow, I am increasingly convinced that while they have been making reasonable tactical judgement, their current strategy is ill adapted to the realities of the moment.
Summers is known for favoring discretion over rules, but this is exactly why the Fed needs to shift to a policy rule. In recently years I’ve made much the same argument, the problem is not the current stance of policy, it’s the entire policy regime, which has no mechanism to prevent a repeat of 2008.
Japan’s essential macroeconomic problem is no longer lack out output growth. Unemployment is low. Relative to its shrinking labor force, output growth is adequate by contemporary standards. Japan’s problem is that it seems incapable of achieving 2 percent inflation. This makes it much harder to deal with debt problems and leaves the Japanese with little spare powder if a recession comes.
I’ve been saying the same thing, for quite some time.
Any consideration of macro policy has to begin with the fact that the economy is now seven years into recovery and the next recession is on at least the far horizon. While recession certainly does not appear imminent, the annual probability of recession for an economy that is not in the early stage of recovery is at least 20 percent. The fact that underlying growth is now only 2 percent, that the rest of the world has serious problems, and that the U.S. has an unusual degree of political uncertainty all tilt toward greater pessimism. With at least some perceived possibility that a demagogue will be elected as president or that policy will lurch left, I would guess that from here the annual probability of recession is 25 percent to 30 percent.
This seems to me the only way to interpret the yield curve. Markets anticipate only about .65 percentage point of increase in short rates over the next three years. Whereas Fed officials’ projections suggest that rates will normalize at 3.3 percent, the market thinks that even five years from now they will be about 1.25 percent.
Summers agrees with us market monetarists; market predictions are more plausible than Fed predictions. Perhaps Summers learned that the wisdom of the crowd applies to interest rate forecasts, from a painful episode as Harvard President.
Despite an impressive resume that includes stints as Treasury Secretary and chief economist of the World Bank, there is a very good reason Summers shouldn’t be in charge of monetary policy: He seems to have trouble with interest rates.
During the financial crisis, Harvard lost nearly $1 billion because of some unusual and ill-judged interest rate swaps that Summers implemented in the early 2000s during his troubled tenure as the university’s president.
Back to the WaPo article:
What does this mean? First, it implies that if the Fed is serious — as it should be – about having a symmetric2 percent inflation target, then its near term target should be in excess of 2 percent. Prior to the next recession — which will presumably be deflationary — the Fed should want inflation to be above its long term target.
Just the opposite. The Fed should aim for below 2% inflation before the next recession, and above 2% inflation during the next recession. That’s not just a good idea, it’s the law. (I.e. an implication of the dual mandate is that inflation should be countercyclical.) In Summers’ defense, he may argue that it’s reasonable to assume that recessions are caused by bad monetary policy, i.e. by fluctuations in NGDP. If that is the case, then inflation will end up being procyclical. And if inflation is procyclical, then to hit the 2% inflation target on average, you’d need inflation above 2% during booms and below 2% during recessions. But again, why not stabilize NGDP growth instead, which would be more consistent with the Fed’s mandate to produce countercyclical inflation?
Those who think that raising rates somehow helps the economy prepare to be counter-cyclical are confused. Given lags, raising rates now would increase the chances of recession, along with the likely severity. Raising inflation and inflation expectations best prevents and alleviates recession.
Summers is right to criticize those who believe that raising rates gives the Fed less more (conventional) ammo to fight the next recession, but his explanation is inadequate. It would give the Fed less ammo even if it did not raise the risk of recession. The real problem is that raising the fed funds target right now would lower the nominal Wicksellian equilibrium rate, and it is the nominal equilibrium rate that determines how much ability the Fed has to ease policy by conventional means (interest rate cuts.)
Experience has proven that Yellen was correct to be skeptical of the idea very low inflation rates would improve productivity. And it is plausible that the error in price indices has increased with the introduction of new categories of innovative and often free products.
This means that if a two percent inflation target reflected a proper balance when it first came into vogue decades ago, a higher target is probably appropriate today. This is another reason to allow inflation to rise above 2 percent.
I do believe that high inflation reduces productivity, but Summers is right that there is virtually no difference in productivity between 2% and 3% inflation. It’s not even clear which one would lead to higher productivity.
Summers concludes:
Over the last 12 months nominal GDP has risen at a rate of only 3.3 percent. We hardly seem in danger of demand running away. Today we learned that Germany has followed Japan into negative 10 year rates. We are only one recession away from joining the club. The Fed should be clear now that its priority is not preventing a small step up in inflation, which in fact should be welcomed, or returning interest rates to what would have been normal to a world gone by.
Instead the Fed should focus on assuring adequate growth in both real and nominal incomes going forward. (emphasis added)
I agree, except for the three words highlighted. The Fed should focus like a laser on NGDP and ignore RGDP, in the hope that stable growth in NGDP will result in more stable growth in RGDP. A subtle distinction, but an important one.
PS. I’m encouraging my daughter to change her last name from Sumner to Summer, when she goes away to college.