Is the Fed evil or misguided?

I say misguided, although many smart people think the Fed is intentionally undershooting its 2% inflation target, or treating it like a ceiling.  That would of course be evil, because it would mean the Fed is lying. Call me naive, but I still don’t quite accept that the Fed is a Trump-like institution. I believe they are misguided.

So what are the implications of my theory?  How can we test it?

If’ I’m right, then I believe that the Fed will eventually see that its reliance on the Phillips curve model has been a mistake. Low unemployment does not cause high inflation.  I expect this realization to occur at some point during 2018, at which time the Fed will switch to an easier money policy—to boost inflation.  I believe this because the market believes it, and (like Larry Summers) I’m a market monetarist.

This is one reason why I expect this expansion to be the longest in American history.  It won’t be the best (the 60s, the 80s, and the 90s were all better), but it will be the longest.  Switching to an easier money policy in the 9th year of an expansion is unusual.  It will prolong the expansion for at least a few more years.

I do not expect the Fed’s undershoot of inflation to cause a recession (although I wouldn’t entirely rule it out–it just seems unlikely.)  The economy has basically adjusted to 1.7% inflation.  The real problems with this are:

1.  A loss of Fed credibility, which will hurt them when the next crisis occurs.

2.  More zero bound episodes.

So the Fed needs to fix this problem.

BTW, there is nothing intrinsically wrong with 1.7% inflation during a period of low unemployment, if the Fed is a flexible inflation targeter.  Indeed in a sense that’s desirable.  But only if the Fed runs above 2% inflation during recessions.  And that’s why the Fed’s Phillips curve thinking is so pernicious.  The Fed fully expects inflation to fall during the next recession—the opposite of what they should be doing.  In that case the Fed needs to generate above 2% inflation during booms, in order to average 2% over the entire business cycle.  They are not doing so.

PS.  Stephen Kirchner directed me to an excellent Martin Sandbu column in the FT.  It does a great job analyzing the recent letter calling for a higher inflation target.  Indeed a far better job than I did in my recent analysis.  Here is the conclusion:

None of this means the target should not be reconsidered. But if there is going to be a change to what the Fed aims to achieve, one can do much better than a higher inflation rate target. One attractive possibility is to target a steadily growing price level rather than an inflation rate, which would require policymakers to pursue higher-than-target inflation for a while to make up for lower-than-target inflation in the past. Another is to consider targeting a path for the nominal size of the economy — nominal gross domestic product level targeting — which would allow for greater monetary stimulus when it is likely to do the most good.

PS.  The Larry Summers link above may be of interest to some people.



32 Responses to “Is the Fed evil or misguided?”

  1. Gravatar of IanS IanS
    15. June 2017 at 07:26

    The Fed could also be preempting political threats to its independence. There seems to be a large enough constituency that is against a) low nominal interest rates and b) any inflation really. So it is raising rates and keeping inflation below 2% to avoid a political backlash.

  2. Gravatar of Effem Effem
    15. June 2017 at 07:36

    The Fed knows well that pushing wealth/gdp to record levels is inherently unstable. A third sequential financial bubble followed by a collapse will absolutely threaten their independence. It’s probably already too late. This cycle looks very much like the last two to me.

  3. Gravatar of ssumner ssumner
    15. June 2017 at 07:44

    Ian, I’m not quite willing to accept the idea that the Fed is evil.

    Effem, The Fed also knows that it has little control over the wealth/GDP ratio

  4. Gravatar of Jerry Brown Jerry Brown
    15. June 2017 at 07:47

    Very nice posts. I agree that Summers calling for higher inflation now means he does not have the same view of what NGDPLT is supposed to do- make inflation rates countercyclical. Or maybe he wants higher inflation now so as to support a higher NGDP level target and does have the same understanding?

  5. Gravatar of Maurizio Maurizio
    15. June 2017 at 07:50

    The impression I get is that the Fed believes that, once inflation goes above 2%, it is impossible or very difficult to bring back down.

  6. Gravatar of David C. David C.
    15. June 2017 at 07:53

    The view that the Fed will come to its senses and back down is in stark contrast to its behavior in this past recovery. Their forecasts and dots have been off for 8 yrs and counting. What’s to say they won’t find another excuse to keep inverting the yield curve and over shooting on the tightening cycle?

    Also, places with institutional inertia have a hard time saying they were wrong and reversing themselves. Data dependence gives them a short term out, but a true shift would mean an abondonement of its Phillips curve fetish and bigger admission: the Fed, as an institution, has gotten it wrong.

  7. Gravatar of IanS IanS
    15. June 2017 at 07:54

    I would not say that the Fed is evil, under the interpretation I propose. I would say it is walking a fine line between fulfilling its employment mandate and not upsetting a large, vocal constituency. If a political backlash led to a tightening of its inflation mandate, then the Fed would not be able to pursue its employment mandate at all. It has already spent a lot of political capital on quantitative easing, maybe it is saving ammunitions for later.

  8. Gravatar of Nathan Taylor Nathan Taylor
    15. June 2017 at 07:58

    Regarding Ian’s raising possibility of avoiding political backlash. Have seen that argument in quite a few places (as has Scott as well I’m sure). So I get Scott’s quick response say this implies the Fed is evil.

    But consider the case where the Fed is *certain* easier money would be politically overturned. And they are in fact always pushing at the limit of easiest possible money given political constraints. Then I think evil (or acting in bad faith) is wrong frame. This version of not doing easier money is then just another version of misguided. Where being misguided is not about economics. It’s being misguided about politics and the Fed’s own soft power. If the Fed makes the case and succeeds it would be politically fine. Point here is this fear of political overturning decisions is clearly a factor in how the Fed behaves. How big of one is arguable. If tiny, we can ignore. If moderate, then it’s important. I suspect people in the Fed are better at economics than politics. Hence any argument that assumes they are naive on politics is (to me) worthy of some consideration. I think it’s a factor. But to be clear, I haven’t read enough first hand accounts of how the Fed works to be sure either way.

  9. Gravatar of ssumner ssumner
    15. June 2017 at 08:32

    Jerry, Saying he doesn’t have the same view is a polite way of saying he doesn’t understand the basic idea of NGDP targeting.

    Maurizio, I don’t think that is their view. It’s not difficult to reduce inflation. I think that they worry that if inflation overshot 2% then bringing it back down would risk a recession. But that doesn’t justify not hitting their 2% target.

    David, That’s not correct—inflation exceeded 2% around 2011.

    Ian, Sorry, but lying by monetary policymakers is always evil, and usually makes for bad policy.

    Nathan, I can’t take seriously the idea that the public is fine with 1.7% inflation but would be outraged by 2%. Where was the criticism of the Fed during the Greenspan era? In any case, even if that were true it would provide no excuse for lying. I take them at their word.

    And if there were some sort of conspiracy, why wouldn’t mavericks like Kocherlakota expose it after he left the Fed? He’s plenty critical of the Fed.

  10. Gravatar of Effem Effem
    15. June 2017 at 08:42

    Disagree that the Fed has little control over wealth/gdp. The risk-free rate plays a key role.

  11. Gravatar of Doug M Doug M
    15. June 2017 at 08:46

    I don’t think anybody really believed that 2% was a target, and in fact always thought of it as a ceiling.

    With the monetary policy changes since 2008, I am not sure that changes to the overnight rate has as much impact as it once did, and we need to now be looking what they do with their other levers (the balance sheet inflation, interest on reserves, etc.)

  12. Gravatar of John Hall John Hall
    15. June 2017 at 09:20

    I’m in the Fed is misguided camp. Cleveland Fed and breakeven TIPs inflation are sinking. The Fed shouldn’t be so focused on fighting inflation right now.

    I disagree with one aspect of your story. You’re critical of the Philips curve. I merely think of the Philips curve as an empirical regularity driven by changes in labor supply/demand, monetary policy, etc. It’s not the underlying theory. That being said, the problem right now is that unemployment is underestimating the degree of labor slack in the economy. Changing the specification to something like prime age employment to population would likely lead to more accurate inflation forecasts.

    Specification is also a big problem for rules-based monetary policy. The Taylor rule relies on output or unemployment gaps. That depends on measuring the potential output or natural unemployment rate correctly, which is very tricky.

  13. Gravatar of Lars Christensen Lars Christensen
    15. June 2017 at 09:27

    Where did Summers get that graph? The answer is here:

    And see here:

    …Yellen’s Fed failed and it is pretty bad.


  14. Gravatar of msgkings msgkings
    15. June 2017 at 09:28

    @ssumner: does the possibility of a new Fed chair, appointed by your buddy Trump, in early 2018 affect your predictions for Fed behavior?

  15. Gravatar of marcus nunes marcus nunes
    15. June 2017 at 09:55

    The Fed has one track mind: Inflation, even when there´s none to speak of.

  16. Gravatar of ssumner ssumner
    15. June 2017 at 10:05

    Effem The Fed has little control over the risk free rate, except in the very, very short run. And it’s the longer run that matters for the wealth/GDP ratio.

    Doug, You said:

    “I don’t think anybody really believed that 2% was a target, and in fact always thought of it as a ceiling.”

    Then why did inflation average 2% between 1990 and 2012?

    And IOR is how they control the overnight rate, so don’t treat it like a different tool.

    John, The problem is that people use the unemployment rate to forecast inflation.

    Lars, You said:

    “Yellen’s Fed failed and it is pretty bad.”

    I’d say that Yellen’s produced a more stable monetary environment than any other Fed chair in history. Yes, she’s failed, but not as badly as some of the other chairs.

    You said:

    Where did Summers get that graph?”

    Great minds think alike.

    msgkings. No, it has no impact on my forecast of Fed behavior. Did Greenspan or Bernanke or Yellen change the Fed’s behavior?

  17. Gravatar of ssumner ssumner
    15. June 2017 at 10:07

    Marcus, Good post.

  18. Gravatar of Doug M Doug M
    15. June 2017 at 10:37

    from 1990 – 2006 was the Greenspan Fed. Greenspan never suggested he was an inflation target-er. And also suggested that price stability was 0% inflation.

    Greenspan did drive it all the way down to 1% at full employment in the late 1990s.

  19. Gravatar of Lars Christensen Lars Christensen
    15. June 2017 at 10:49


    The Fed is not easing and the market is not expecting the Fed to ease. Rather since March inflation expectations – both market and survey – have dropped rather significantly. If Yellen was providing nominal stability then inflation expectations would be stable. They are not. Just over the past 24 hours markets inflation expectations are sharply down.

    Nominal stability is not a situation where inflation expectations are gradually declining. That is what is happening now. In fact this is rather similar to Japan over the past two decade. Everytime there is a negative shock to money-velocity – small or large – the Fed allows inflation expectations to drop further, while any sign of acceleration in nominal demand is met by a tightening of monetary conditions.

    US monetary policy is highly asymmetrical.

  20. Gravatar of ssumner ssumner
    15. June 2017 at 11:32

    Doug, My point is that as of 2012 the Fed had been delivering roughly 2% inflation for decades, give or take 1%. And yet you claim that no one expected the Fed to target inflation at 2%? Really? No one expected them to produce the sort of inflation rate they had been producing for decades, once they started targeting it?

    How do you explain that the consensus private sector forecast of inflation is currently 2%. Are these not people?

    Lars, I meant that NGDP growth has been more stable under Yellen than under other Fed chairs.

    When I said the Fed will ease at some point, I meant that I expected the Fed to at some point change its mind and not raise rates according to the current path in the dot plots. That’s also what markets expect. I agree that this will not constitute an easy money policy in any absolute sense, just easier than current policy.

  21. Gravatar of Alec Fahrin Alec Fahrin
    15. June 2017 at 11:47

    Mr. Sumner,

    In response to the post, I believe this was a mistake by the Fed. I also thought December 2015 and March this year were mistakes. My impression is that they pushed themselves into this rate hike because they are afraid that to back off would damage their credibility. That is what occurred multiple times in 2015 and 2016.
    Do you believe these previous events have affected the Fed today?

    Furthermore, I’d love if you could do a post concerning the March 2016-present Chinese monetary/regulation tightening cycle. Many important data points came out in the last week. Essentially the credit creation has fallen sharply (about 10% YoY) while M2 growth fell to a record low of 9.6% YoY. The overall economy has held up, although real estate investment growth slowed. I wonder what your thoughts and recommendations are for the PBOC on this issue.

    The CPI in the late 90’s was relatively low, but in 1999-2001 when the unemployment rate was about 4%, the inflation rate averaged 3.2%. Only in the aftermath of the Asian Financial Crisis in early 1998 did the CPI fall to around 1.5%.

    As a sidenote, Indian CPI inflation fell to 2.2% YoY (mostly because of the sharp economic slowdown), but the RBI has not decreased interest rates. They got called in by the government today for a vocal “discussion”.

  22. Gravatar of Cooper Cooper
    15. June 2017 at 12:51

    Aren’t most of our problems just the result of the fact that total factor productivity growth has been terrible for the last decade?

    * TFP growth from 1954 to 1964 – 11.2%
    * 1964 to 1974 – 5.7%
    * 1974 to 1984 – 6.4%.
    * 1984 to 1994 – 9.4%.
    * 1994 to 2004 – 14.6%
    * 2004 to 2014 – 4.1%

    That’s the wall we’re running into. You can’t grow the economy at the rates we saw in the 1980s/90s without doubling or tripling our existing anemic productivity growth.

  23. Gravatar of msgkings msgkings
    15. June 2017 at 13:53

    @Cooper: correct, and it’s hard to argue we will go back to those growth rates. And that may be ok, Japan is an aging, slow growing economy and still a safe, prosperous, first world place.

    It may be hard for the American mindset to accept though, our current malaise is probably that, adjusting to the new normal. The economy is fine, but we got used to booming and booming ain’t on the menu.

  24. Gravatar of John Hall John Hall
    15. June 2017 at 15:35

    Scott, to be a bit more specific, what you should care about is the people in control of monetary policy use unemployment to forecast inflation and face no consequences when their decisions are wrong. If market monetarist ideas were accepted, then anyone in the public would be free to use unemployment to forecast inflation (and then generate an NGDP forecast). However, they might lose money on their NGDP futures. That’s the beauty of your approach: you weed out the bad ideas & forecasters.

  25. Gravatar of Benjamin Cole Benjamin Cole
    15. June 2017 at 16:38

    There is a lot of territory between “evil” and “misguided” including that land known as “compromised”.

  26. Gravatar of Ricardo Ricardo
    15. June 2017 at 17:20

    From more than 10 years of daily listening to Bloomberg Radio, I hear interviews often with current and former Fed officials. Every once and while, some will hint at their thought on the inflation target. And, there seems to be a continuum of opinions. A few (well-known hawks) hint that they think of 2% as their ceiling, one or two others that it should be symmetrical, but many don’t seem to have a strong opinion on ceiling vs. symmetrical.

  27. Gravatar of Grant Gould Grant Gould
    16. June 2017 at 02:53

    A non-economist here, so do disregard this if it is incoherent.

    One impression I get from the various fed member interviews on the Macro Musings podcast is that the fed is treating 2% as a sort of second-order target — rather than target 2% directly they are targeting a rule that itself targets 2%, in hopes that they will arrive at 2% with a zero first-derivative.

    For instance, one such rule might be to always have a short-term target of half the difference between the current inflation rate and 2%. That could both plausibly be described as a (long-term) 2% target and also never generate an overshoot.

    This would always look asymmetric in practice and still be perfectly symmetric in the minds of the Fed; it would also consistently produce the observed result that targeting zealots like yourself and Fed members seem to always be talking past each other as if you mean entirely different things by the words “target.”

  28. Gravatar of Billl Billl
    16. June 2017 at 04:17

    I think one problem is this formulation: “smart people think THE FED IS intentionally undershooting its 2% inflation target, or treating it like a ceiling.” The Fed has many voting members. If some view it as a symetrical target and some as a ceiling or soft ceiling, the results of their voting and discussions will produce results that look like a ceiling. I don’t think any of members of the Fed are evil – they’re just human. They can say “symetrical” but if we test it, they (even the members who favor symmetry) very much appear to prefer 1.7% to 2.3%, 1.9% to 2.1% etc. It’s actually another good reason for changing to an NGDP target (preferably NGDPLT) because I think the members could be more comfortable trying to truly symetrically target 4% NGDP than 2% inflation.

    Bernanke to Congress in 2013: “my inflation record is the best of any Federal Reserve chairman in the postwar period – or at least one of the best,” he said, citing the 2 percent average inflation rate.
    Of course that average hides inflation over 5% early in the recession (while it was still mild) and below 0% during it – not only volatile, but procyclical.

    Lastly, the Fed members seem to think steady and predictable changes in the Fed Funds rate are more important than steady NGDP growth or at least steady or counter-cyclical inflation. I think they were very proud of the steady march of the 25bps increases from 2004 to 2007. Never mind that it produced the worst recession and worst financial crisis of the last 70 years.

  29. Gravatar of ssumner ssumner
    16. June 2017 at 04:55

    Alec, I suspect they actually do fear overheating, and higher inflation. Remember, the Phillips curve approach is deeply engrained over there. In fairness, the private sector consensus also sees 2% inflation. so it’s not obvious that they are wrong.

    The Chinese seem to do a pretty good job with monetary policy. AFAIK, the big problem in China is lots of debt issued by state owned banks and going into projects of dubious value. That may eventually lead to a debt crisis.

    Cooper, Yes, that’s a “real” problem, but monetary policy deals with nominal aggregates like the CPI and NGDP.

    John, Yes, that’s the advantage of markets guiding policy.

    Ricardo, Maybe, but the official Fed position is crystal clear.

    Grant, If what you are saying is that they plan to return to 2% gradually, then I agree. But they keep pushing off the date that they’ll get there.

    Bill, That may be right today, but it was not right before 2008, and I think we’ll need more time to be confident that these are not just misses, as they claim.

  30. Gravatar of Majromax Majromax
    16. June 2017 at 06:01


    >> I expect this realization to occur at some point during 2018, at which time the Fed will switch to an easier money policy—to boost inflation. I believe this because the market believes it, and (like Larry Summers) I’m a market monetarist.

    What makes you say that the market believes that the Fed will switch to an easier money policy? If you’re looking just at interest rate spreads, I think that data is compatible with the idea that we’ll experience a slowdown followed by easing from the Fed.

    But as you point out repeatedly, that is not in fact easier monetary policy; at best it is neutral monetary policy with interest rates following rather than leading the Wicksellian rate.

    Easier money would require either that the Fed change its mind when presented with economic data that matches its current expectations or that the Fed overreact (compared to neutrality) when economic data comes in below current expectations. (Or underreact with faster growth, but this seems unlikely.)

  31. Gravatar of flow5 flow5
    16. June 2017 at 14:45

    Call a spade a spade. This is a statement by a stagflationist, where the payment of interest on excess reserve balances destroys money velocity and AD (a theoretical monetary policy blunder that delivers subpar R-gDp and N-gDp growth, by one who literally advocates, and is responsible for, dropping our standard of living, skewing income distribution, and increasing social unrest, e.g., increasing murder rates).

    And the very fact that savings, which are funneled through non-bank conduits, increases the supply of loan-funds (but not the supply of money), proves that bank-held savings are un-spent and un-used, lost to both consumption and investment, indeed to any type of expenditure.

    In the post WWII years (the “Golden era in U.S. economics), increased money velocity financed about 2/3 of an expanding gDp, while the increase in the stock of money financed only 1/3. Since 1981, the situation has been reversed. All economists are universally, both arrogant and ignorant.

  32. Gravatar of ssumner ssumner
    17. June 2017 at 12:57

    majromax, Good point. See my reply to Lars, above.

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