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.



17 Responses to “Summers on monetary policy”

  1. Gravatar of foosion foosion
    15. June 2016 at 08:36

    Scott, what do think of Evans view that the Fed should wait until inflation hits 2% to raise versus the Yellen view that it’s better to raise slowly in advance rather than sharply at 2%?

    Apologies if you’ve written on this.

  2. Gravatar of ssumner ssumner
    15. June 2016 at 08:54

    foosion, Of course I think the Fed should ignore inflation entirely. But if they insist on targeting inflation, then they should choose the path that provides the most stability to employment.

    I don’t have strong views on that debate, but I think the real problem now is that the market expects the Fed to undershoot inflation in the long run, so in practical terms my policy advice is closer to Evan’s dovish position, albeit for slightly different reasons.

  3. Gravatar of Michael Michael
    15. June 2016 at 08:55

    > Summers is right to criticize those who believe that raising rates gives the Fed less (conventional) ammo
    surely you mean “more” here

  4. Gravatar of Steve Steve
    15. June 2016 at 09:14

    “the annual probability of recession for an economy that is not in the early stage of recovery is at least 20 percent”

    Things with 20% annual odds:
    – recession
    – inflation hitting 2%
    – something snapping in Mid-East


  5. Gravatar of Steve Steve
    15. June 2016 at 09:25

    The problem with a technocrat dove like Yellen is that you end up with a dove-eating Borg. The techno always wins.

    There are two solutions:
    – reprogram the Borg
    – pick someone with a strong enough personality to override the Borg

  6. Gravatar of E. Harding E. Harding
    15. June 2016 at 09:27

    How about go all the way and change it to “Summers”?

    Seriously, though, Sumner is a good name -William Graham and Charles are the most famous.

  7. Gravatar of msgkings msgkings
    15. June 2016 at 09:34

    No the most famous Sumner is Gordon Sumner, known better by his stage name: Sting.

  8. Gravatar of Richard A. Richard A.
    15. June 2016 at 09:53

    With regard to Japan, the inflation rate is irrelevant. It’s nominal GDP growth that one should follow.

  9. Gravatar of Brian Donohue Brian Donohue
    15. June 2016 at 10:13

    “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.”

    I’m guessing this coincided with Krugman’s shrewd and publicly-proclaimed advice in favor of locking in a fixed-rate mortgage around the same time. Interest rate geniuses.

  10. Gravatar of ssumner ssumner
    15. June 2016 at 11:31

    Michael, Thanks, I corrected it.

  11. Gravatar of Benjamin Cole Benjamin Cole
    15. June 2016 at 14:58

    Excellent blogging.

    When did mainstrean US economists become cackling hens at the prospects of 3% inflation? Remember Milton Friedman bashing the Fed for being too tight—in 1992 when the CPI was a little north of 3%.

  12. Gravatar of Rajat Rajat
    15. June 2016 at 16:00

    “Just the opposite.”

    Scott, speaking of “I told you so’s”, this is what I’ve been saying all along: Most observers – including Summers apparently – see the dual mandate (and the RBA’s flexible inflation target) as permitting policy errors and lags rather than the (sensible) way you see it. Just sayin’! I’m generally not a conspiracist, but I can’t help thinking it suits central bankers for people to think this way, as it reduces their accountability.

    Why the change to Summer – is it that people spell Sumner wrong or are you too famous now? (Or is she going to Bentley?)

  13. Gravatar of ssumner ssumner
    15. June 2016 at 18:26

    Rajat, I agree that the regime “permits” errors, but can we agree that one should not aim to commit errors? The goal has to be countercyclical inflation. Even the ECB’s simple inflation target dominates procyclical inflation.

  14. Gravatar of Major.Freedom Major.Freedom
    15. June 2016 at 19:07

    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.

    In the hopes? This theory has already been debunked. Socialist monetary activity cannot be absorbed permanently into the free market process. They are incompatible. Both cause permanent instability against the other, the same fundamental way that private property and socialism are incompstible, the same way absence of market signals and presence of market signals aremincompatible, the same way that violence and peace are incompatible.

    In addition, not all equally sized NGDPs are equal in terms of relative distribution of spending. A state determined 5% NGDP growth is not equal to a market determined 5% NGDP growth rate. A state determined 5% NGDP growth rate brings about a non-market determined relative distribution of spending. This has consequences on relative resource and labor allocation, and THIS is what determines whether there will be an inevitable recession or not. Recessions in our ecomomy are not “inadequate demand”. Declines in spending are but a symptom of real discoordination, as individuals have the choice to spend their money that exists but choose not to do so at the same historical rates.

    If the Fed were to permanently target NGDP, the “hope” of permanent stability will be, just like all previous “rules”, a faith based, vain hope. A permanent pressure by the state on free market activity, a permanent pressure on inflation despite what is left of market forces putting pressure towards deflation as the cure, cannot result in anything but ever growing real discoordination. This is because a permanent pressure on inflation is at the same time a permanent pressure against a market determined relative distribution of spending. It is not true that as long as the Fed focuses on NGDP, the market will be affected only by the single number representing NGDP.

    The market cannot be forced to spend a particular aggregate sum of money without also being affected in how it relatively distributes spending. This is because free market prices and interest rates are not observable. It does not wash out. The Fed by virtue of it increasing the money supply is necessarily affecting interest rates and relative spending even if it does not intend to do so. This distortionary intervention leads to malinvestment and inevitable corrections. The story of Australia, commonly cited by (anti) market monetarists as evidence of the compability of markets and socialism, fail to grasp that it is not labor hours worked that signals economic health. It is not unemployment. It is economic coordination. Higher aggregate employment can be associated with higher discoordination and lower employment can be associated with lower discoordination. There is no absolute necessity that economic health requires permanently growing output and employment. Growing output and unemployment are only optimal when they are required to accomplish actual consumer ends. These ends are only observable in a context of free trade. They cannot be assumed as variables that “should” grow without question. At any rate NGDP in Australia has grown to be 40% higher today than it was late 2008, and yet unemployment has grown to be 2% higher today than it was late 2008. So much for the Australia as evidence canard. “Hopefully” there will be another cherry picked example to show it works until it doesn’t?

    The concept of economic calculation is completely absent in all of the blog posts here.

  15. Gravatar of Rajat Rajat
    15. June 2016 at 19:52

    Totally agree that should be the goal. I’m just point out: (1) that’s not how most people think about it and often it takes some explaining as for many it’s counter-intuitive (even Larry Summers) and (2) it suits central bankers for people to take an interpretation that forgives CBs’ errors; therefore, who is going to take the time to explain the more sensible way to think about it? A few MMs and who else?

  16. Gravatar of ChrisA ChrisA
    15. June 2016 at 21:10

    Scott – maybe you already covered it and I missed it – but why do you think high inflation affects productivity? Is this based on empirical data or a theoretical model?

    I guess if I were an investor in an environment with high wage inflation I would tend to favor capital investments that reduced my labor cost more than in a low wage inflation environment if only to reduce the uncertainty of my business. This would be especially true if the future path of inflation were uncertain.

    Taking it further, during periods of high inflation, we tend to see low real interest rates (so called overstimulation by Austrians). In that case, where you can borrow for essentially negative real interest rates shouldn’t you also see higher capital investment?

  17. Gravatar of ssumner ssumner
    17. June 2016 at 09:53

    Rajat, I agree that some are confused, but this isn’t rocket science. Start with a pure inflation target, where inflation is acyclical. Then add the second mandate, for employment. What happens to the cyclicality of inflation? Why doesn’t everyone see that?

    And it’s a vase, not two faces. Why doesn’t everyone see that too. 🙂

    ChrisA, Demand stimulus has little or no long run impact on productivity. Rather what matters are supply side policies. Higher inflation raises the effective tax rate on capital, and thus reduces saving and investment.

    Monetary policy (within reason) has no long run effect on growth. I agree that in the short run it may reduce real rates, boost investment, and boost growth. But that’s just a short run effect.

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