I generally don’t make predictions, I infer market predictions.  But this time I’ll make a specific policy prediction—and hope I am wrong.  Indeed I hope the fact of my prediction will in some small way help to cause it to be wrong.

I predict the Fed will exit the zero rate policy prematurely.  Here’s why:

The first zero rate trap that I am aware of was in the 1930s.  The Fed tightened monetary policy prematurely, in 1936-37.  We went right back into deflation.

The second example that I am aware of is Japan in the 1990s.  The BOJ exited the trap prematurely in the year 2000, when the raised rates.  Japan went right back into deflation, and the BOJ cut rates back to zero.

The third example that I am aware of is Japan in the 2000s.  The BOJ tightened monetary policy in the year 2006, when it raised rates and reduced the base by 20%.  Japan went back into deflation, and the BOJ cut rates back to zero.

The fourth example that I am aware of is the ECB in recent years.  The ECB tightened policy in the spring of this year, when they raised rates.  The European recovery was aborted, the debt crisis got much worse, and inflation expectations fell sharply.  How long before they reverse course?

The only non-premature case I know of was in 1951, when the Fed ended the interest rate pegging program.  It took a World War and a middle size war, plus a major devaluation, to get enough inflation so that the Fed could operate in a normal interest rate environment.  And inflation wasn’t even very high during 1952-64.

So what’s more likely, will the Fed exit prematurely, or will we end up with high inflation?  History says four-to-one it’s too early.  And the reason this is almost inevitable is that big institutions follow common sense intuition.  They think low rates are dangerous, and want to exit the zero rate policy as soon as they can.  Low rates are problematic, but exiting too soon is even worse.  Bet on a premature exit.

Update:  Just to be clear, my worry isn’t that there will be a premature exit in 12 to 18 months (which I think unlikely), but that there will be a premature exit in 6 or 8 years.  That things will be so bad that even that far out is premature.  Impossible?  Consider Japan.



20 Responses to “Prediction”

  1. Gravatar of bill bill
    5. October 2011 at 08:57

    i agree. 100% – not 80% 🙂

  2. Gravatar of Steve Steve
    5. October 2011 at 09:08

    Richard Fisher has stated his condition for supporting QE3:

    Fisher Says Fed Has Ammunition If U.S. Turns ‘Horrific’

  3. Gravatar of Gabe Gabe
    5. October 2011 at 09:12

    I predict that the people of this country will give the Fed the power to secretly decide these issues for too long. We will not get clear decision making rules that are currently in effect and the insiders will use the turning points to make higher returns than people like us(known as “the herd” in the insider crowd).

    Earnest economist will carry on debates with teleprompters in the hopes of figuring out why the fed statements are full of paradoxes, unlcear phraseology and logical errors. Eventually the anger at the Fed will grow even larger as the thought leaders on the internet realize the central bankers are not altruistic technocrats…that is merely the PR that had to be put in place in order to get the money printing power in the hands of the inner circle.

  4. Gravatar of Dan Kervick Dan Kervick
    5. October 2011 at 09:12

    I don’t think the Fed is going to exit the zero policy prematurely. They are just calling for the fiscal authorities to pick up a hammer and start doing their job, and have sent a signal that the political branches can’t count on ever-expanding monetary policy substitutes for clear fiscal policy jobs.

    Pavlina Tcherneva has produced a whimsical, but possibly accurate, take on what Bernanke’s current thinking might be:

  5. Gravatar of Gabe Gabe
    5. October 2011 at 09:16

    It almost seems the question of tighten too early, tighten too late is part of a dialectic used to keep attention away from the real problem.

    Why do we allow insiders to blow bubbles and pop them in a opaque way that ends up whipsawing the average man, while making the money power elite rich beyond belief?

  6. Gravatar of dtoh dtoh
    5. October 2011 at 09:16

    I suspect part of the BOJ thinking on rates in the 90s was to create a rate environment most likely to improve bank profitability in order to rebuild the bank equity that had been wiped out by the fall in real estate values. Low rates meant that a lot of the bad debt didn’t need to be written off because borrowers could pay the nominal interest rates and avoid official default. As I recall a lot of BoJ activity seemed to focus around the semi-annual bank earning announcements.

  7. Gravatar of Morgan Warstler Morgan Warstler
    5. October 2011 at 09:17

    Fisher reminds that 1974 was much worse:

    Which Scott you’ve agreed with me about!

  8. Gravatar of dtoh dtoh
    5. October 2011 at 09:18

    One other thing. I think Bernanke is being obtuse simply because he can’t come out and say outright that his goal is to torpedo Obama’s re-election prospects.

  9. Gravatar of Benjamin Cole Benjamin Cole
    5. October 2011 at 10:09

    You know, following economics has become less and less rewarding—and now this from Scott Sumner.

    Don’t get me wrong, this is a perfectly intelligent and insightful post.

    But, can I get a job as a bartender in Tahiti or something–and wake me in 20 years, when this recession might be over.

  10. Gravatar of Silas Barta Silas Barta
    5. October 2011 at 11:00

    I predict that if NGDP surges, while unemployment, economic growth, inflation, hourly wages, and general purposefulness of modern production get significantly worse, Scott_Sumner will declare victory and call it a vindication of his views.

  11. Gravatar of Peter Peter
    5. October 2011 at 11:10

    “They think low rates are dangerous, and want to exit the zero rate policy as soon as they can. Low rates are problematic, but exiting too soon is even worse.”

    This reminds me of this Svensson quote (on Swedish policy in 2010):

    “Monetary policy also appears to have strived, through references to the abnormally low repo rate, to normalise the level of the repo rate. This is despite the fact that the repo rate should not be a target variable for monetary policy, but merely an instrument without any inherent value. “

  12. Gravatar of ssumner ssumner
    5. October 2011 at 12:32

    Thanks Bill.

    Steve, Here’s what he should say: If expected demand growth is not absolutely PERFECT, we will change policy until we (or the markets) expect precisely optimal demand growth.

    Maybe I should tell my wife that I’ll get a haircut if my hair become “horrific.”

    Gabe, Yes, but the public also doesn’t have a clue. The Fed should be removed from these decisions, but God knows what will replace it (probably not my NGDP futures targeting.)

    Dan, I added an update to address your comment. Thanks for the link.

    Gabe, Right now the Fed is rapidly reducing the wealth of the “money power elite.”

    dtoh, So why did they repeatedly raise rates.

    Morgan, Yes, 1974 was a very bad year.

    Ben, That job sounds tempting.

    Silas, I’m making two claims, If NGDP rises 6% to 8% and the unemployment rate doesn’t fall, then one of my claims is wrong.

    Peter, Thanks, Svensson was very insightful.

  13. Gravatar of Morgan Warstler Morgan Warstler
    5. October 2011 at 15:40

    Now it is 6-8%!!!!

    Well, I’ll take this at least as you finally saying level 3% NGDP is the same thing as hard money / King Dollar.

  14. Gravatar of Scott Sumner Scott Sumner
    5. October 2011 at 15:59

    Morgan, Silas asked for a NGDP “surge.”

  15. Gravatar of ZG ZG
    5. October 2011 at 16:07

    “The ECB tightened policy in the spring of this year, when they raised rates”

    But aren’t higher interest rates just a sign that monetary policy has been too easy? I know, I know it’s not the same, but I think you should do a post clarifying when a central bank is “following a Taylor Rule” and thus interest rates are merely an indication of previous tightness/easyness, and when the rates rise exogenously/as a monetary shock such as the ECB raising rates = tightening of monetary policy. And how one can tell the difference between the two.

  16. Gravatar of Morgan Warstler Morgan Warstler
    6. October 2011 at 05:20

    NGDP going to 5% right now would not be a surge?

  17. Gravatar of Floccina Floccina
    6. October 2011 at 05:59

    You do not expect inflation for 6 to 8 years! Wow that makes stocks like KO, PG, JNJ etc. that have safe yields over 2.5% look really good!

  18. Gravatar of Scott Sumner Scott Sumner
    6. October 2011 at 11:50

    ZG, I’ve consistently argued that falling NGDP expectations are a sign of tighter money. It’s other people who regard rising interest rates as tightening. I was discussing what other people think, or would think if actually considered what’s going on, regarding the ECB move.

    Morgan, No. It would be an increase from 4%, not a surge.

    Floccina. I SAID STOCKS WERE A GOOD INVESTMENT!! (right before they crashed.)

  19. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. October 2011 at 20:07

    Scott wrote:
    “I predict the Fed will exit the zero rate policy prematurely.”

    If that prediction comes true I predict that I’ll be out of the country well before then.

    1) I have absolutely no fecund family members to hold me here. (I wonder why?)
    2) I’ll have much greater money making opportunities on other parts of the planet (i.e. Australia it so turns out.)
    3) I’ve grown increasingly dissapointed in the American model. It’s clearly failing (or flailing).

  20. Gravatar of Scott Sumner Scott Sumner
    8. October 2011 at 16:37

    Mark, Maybe I’ll join you down under.

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