Are rate increases unthinkable?

Bloomberg says that some pundits are beginning to contemplate the possibility that the Fed’s next move might be up, not down:

Summers, a Harvard University professor and paid contributor to Bloomberg Television, suggested a perhaps 15% chance that the next Fed move is an increase. Mark Nash, who manages absolute return macro funds at Jupiter Asset Management, puts the odds at 20%.

Even some who do expect rate cuts have advocated taking out insurance on that bet. BMO’s Davis has been shorting two-year Treasuries since December, though covered half of that position amid the climb in rates since the start of the year.

At Societe Generale SA, Chief FX Strategist Kit Juckes told clients in a report last week that if “the US economy re-accelerates, the Fed will eventually have to tighten again and the dollar will rally,” possibly back to 2022’s all-time high.

Clearly the markets believe the next move will be toward lower rates, but no one should be surprised by the fact that a rate increase is possible. In an efficient monetary policy regime, there would be roughly a 50-50 chance of a rate increase on any given day. (Under an efficient regime, policy would set the target fed funds rate to the nearest basis point, and that target would be adjusted daily in response to a continual flow of new information.)

Even with our current inefficient regime, policy moves should be at least somewhat unpredictable. For simplicity, define easy money as a policy rate below the natural rate and tight money as a policy rate above the natural rate. If the central bank is trying to set rates at the (unobservable) natural rate of interest, then they would be expected to overshoot 50% of the time and undershoot 50% of the time. More importantly, the errors made by a rational central bank should be completely uncorrelated with the level of interest rates.

This means that you would not necessarily expect a high interest rate policy to be any more contractionary than a low interest rate policy.

Of course you can imagine models where high rates are correlated with tight money, as in the case when the central bank intentionally sets rates above their estimate of the natural rate in order to control inflation. But in general, policy errors should be uncorrelated with the level of rates. So “make up” policies to correct previous policy errors should be hard to forecast.

The Fed has now set rates at a level expected to produce a soft landing. If they overestimated the natural rate of interest they might deliver a hard landing, and if they underestimated the natural rate we might get no landing at all. In the latter case, inflation might stay stubbornly above target, requiring further rate increases.

Two years ago, almost no one correctly forecast the recent path of interest rates. The same could be said about interest rate forecasts in early 2020, or early 2019. I don’t know what will happen to rates over the next two years, but I have very little confidence that things will play out in the way the markets or the Fed currently expect. There could be surprises in either direction.

I see people cherry picking some obscure inflation metric which has hovered around 2% for 6 months. But price inflation is not the right variable to look at. In order to have lower interest rates, we need a slowdown in wage inflation and NGDP growth. If wage inflation gets stuck at 4.5%, then interest rates are headed higher. I still think it’s likely that wage inflation will slow, but recent price inflation moderation doesn’t reassure me at all.

In an efficient monetary regime (NGDPLT), policy errors in either direction would be equally bad. But we don’t have level targeting. In addition, recent policy errors have been in the direction of an excessively expansionary policy. For that reason, the damage from a somewhat overly expansionary policy in 2024 would be greater than the damage from a somewhat overly contractionary policy in 2024. The longer that wage inflation stays elevated, the more difficult it will be to bring it down.

PS. Here’s the FT:

Earlier this month, Australia’s central bank — the Reserve Bank of Australia — decided to keep its main interest rate on hold at 4.35 per cent. Nothing alarming there. But in a statement, rate setters indicated that the next move could conceivably be up, not down. . . .

Assumptions for swift rate cuts are also on shaky ground in New Zealand. Last week, regional bank ANZ flipped its view on what the Reserve Bank of New Zealand will do next. As recently as January, it thought the central bank would start pruning rates back in August. Now it is forecasting two more rate rises by April, taking the benchmark rate to 6 per cent.



18 Responses to “Are rate increases unthinkable?”

  1. Gravatar of Michael Sandifer Michael Sandifer
    20. February 2024 at 17:19

    The 5-year inflation breakeven is just over 2% in core PCE terms, and various other forward-looking metrics likewise indicate monetary policy is expected to be a bit loose. Hence, without some more positive real shocks, we should expect the Fed to be more likely tighten policy soon.

  2. Gravatar of Bobster Bobster
    20. February 2024 at 22:18

    “The longer that wage inflation stays elevated, the more difficult it will be to bring it down.”

    This is extremely concerning. In an election year, the fed is not going to want to make tough choices.

    I remember you mentioning during the great recession that the fed follows the consenus of economists, which currently seems to be that wage inflation isn’t elevated, or if it is, that’s a good thing.

  3. Gravatar of Solon of the East Solon of the East
    21. February 2024 at 00:46

    This post seems true. If the Fed is in the ballpark, then at any time rates might be nudged higher or lower.

    A more-interesting question is whether the Fed should sit on its balance sheet or not.

    I can’t see how selling off the balance sheet will do anything much, except leverage up taxpayers.

    Some FTPL types even think a strong central bank balance sheet is anti-inflationary, as it helps ensure the government has money coming in to handle debts.

    “Inflation Is Not Always and Everywhere a Monetary Phenomenon” (Economic Letter, Federal Reserve Bank of Dallas, June 2014), Antonella Tutino and Carlos E. J. M. Zarazaga

    That’s what the Fed scholars wrote.

    Interesting to ponder that the Fed is just one central bank, but with three other major ones in a world of globalized capital markets.

    OT: Bank Indonesia recently financed (bought bonds directly) government deficits in that nation, to get through the C19 pandemic. No apparent ill effects.

    Of course, the Bank of Japan has a gigantic balance sheet in a nation with huge national debts. And inflation rarely a problem.

    World’s best stock market, now worth more than China’s.

  4. Gravatar of spencer spencer
    21. February 2024 at 06:33

    Loans = Deposits. An increase in one deposit classification depletes another classification dollar for dollar. All monetary savings originate within the payment’s system. And banks don’t lend deposits. All monetary savings are lost to both consumption and investment.

    The composition of the money stock has changed. That’s a “sea change”. AD will be higher as a result, and so will interest rates.

  5. Gravatar of steve steve
    21. February 2024 at 08:37

    Does Powell want to be remembered as an Arthur Burns or a Paul Volker? He’s intelligent. My bet is Paul Volker.

  6. Gravatar of ssumner ssumner
    21. February 2024 at 10:11

    Bobster, You said:

    “the consensus of economists, which currently seems to be that wage inflation isn’t elevated, or if it is, that’s a good thing.”

    If that’s true (and I don’t know if it is), we’re in even worse shape than I thought.

  7. Gravatar of Kevin Erdmann Kevin Erdmann
    21. February 2024 at 13:37

    Steve, fortunately JPow! is a Benjamin Strong. Let’s hope he’s in good health!

  8. Gravatar of Sara Sara
    21. February 2024 at 20:49

    The most striking problem with NGDPLT, whether it’s nominal GDP or nominal income, is that it would lead to tyranny.

    Those who support NGDPLT, support a merger between corporations and state, either wittingly or unwittingly.

    When you target total output, and a few corporations exceed the target, the first thing policy makers will do is villify organizations for failing to meet the target. This new scapegoat will be the enemy of the people, and lo and behold your virtuous politicans will be the hero.

    They will do precisely what Hitler did. They’ll place liaison’s on the board of the largest companies to micromanage activities. Every worker will receive a digital workbook. Corporations will be forced to increase or decrease production as deemed fit by the state. Workers will be forced to produce within certain parameters. And production will be controlled by apparatchiks.

    Another dystopian scenerio would be a state that fines companies into submission for going over a particular target.

    How about ending the Fed. End bank regulation. End the fictious 250,000 FDIC. Let anyone start a bank. And let the buyer beware. Money will flow to the most secure and productive places. Some will fail. Some won’t. That would be an example of liberty.

  9. Gravatar of ssumner ssumner
    21. February 2024 at 21:37

    “When you target total output”

    LOL, Sara provides nonstop entertainment. NGDP has nothing to do with “total output”. That’s RGDP.

  10. Gravatar of Ricardo Ricardo
    21. February 2024 at 22:59

    Sumner loves power, so it wouldn’t surprise me if tyranny was his objective.

    But this comment: “Of course, the Bank of Japan has a gigantic balance sheet in a nation with huge national debts. And inflation rarely a problem. World’s best stock market, now worth more than China’s.”

    I can tell you’ve never been to Japan.

    You know what people in Japan dream of the most? Do you know what every college student in Japan prays for?

    They want to get an international financial banking job in preferably Hanoi, Bangkok, Singapore, or if that fails, anywhere in Europe, U.K. or the U.S. Tokyo is one of the least livable cities in the world. 60sqmts will cost you a million dollars. You’ll be renting until you’re 50. Most who rent live in tiny rooms, just big enough for their laptop, a rice cooker, a few suits, and a bed. Nobody can save anything in Tokyo unless they have old money, and/or own their home.

  11. Gravatar of spencer spencer
    22. February 2024 at 06:05

    Targeting N-gDp will reduce the FED’s policy blunders. The FED takes too long to act on its other signals.

  12. Gravatar of scorz scorz
    22. February 2024 at 11:59

    I’ve been thinking about interest rates a lot recently and was wondering is it possible for high rates to lead to more growth?

    Theory of change is: higher rates increase costs on firms > bad firms start going under > labor goes to more productive firms > more productive firms add more to GDP

    Especially considering our low unemployment and labor shortage

    I recently heard Tyler mention that most of the growth countries get from opening up to international trade is from bad firms going under, seems like the same logic would apply here

  13. Gravatar of ssumner ssumner
    22. February 2024 at 12:03

    scorz, No, that’s reasoning from a price change. You can’t talk about the effect of rate changes without knowing why rates changed.

    Almost all statements along the lines of “An increase in rates cause X” are wrong.

  14. Gravatar of scorz scorz
    22. February 2024 at 12:43

    What if instead I said:

    A decrease in (or just not increasing) the money supply leads to money being more expensive (higher interest rates) which increases costs on firms > bad firms start going under > labor goes to more productive firms > more productive firms add more to GDP

  15. Gravatar of Edward Edward
    22. February 2024 at 17:52

    This is why everybody thinks academics are idiots:

    This is a self proclaimed Ukrainan/American Economist who works at Case Western University (must be one of those diploma mills).

    He says: “According to Trump, russia defeated Hitler?! The ignorance and stupidity of this man has no bounds.”

    Russia, of course, did defeat Hitler. They lost nearly 30M people on the eastern front. I swear that Economists have to be the dumbest social scientists after gender studies. Your profession is replete with foot-dragging, knuckle-dragging neanderthals. Idiots to a degree that is almost inconceivable.

    I mean, you want to talk about entertainment. This truly is entertainment. It’s also bloody scary that anyone would give him the title Ph.D. I’m guessing he doesn’t know that Ukraine fought for the Nazis in WW2 either.

  16. Gravatar of ssumner ssumner
    22. February 2024 at 18:27

    scorz, I don’t see much empirical support for that claim. For example, in the early 1930s there was a big decrease in the money supply and GDP fell sharply.

  17. Gravatar of Mark C Mark C
    22. February 2024 at 19:02

    If natural rate is indeed around where the FFTRs are, then why has the natural rate risen so much in recent years? What is the mechanism behind the rise?

  18. Gravatar of ssumner ssumner
    22. February 2024 at 19:44

    Mark, The natural rate is highly correlated with NGDP growth, which has been extremely high in recent years.

Leave a Reply