The next 3 years will definitely be interesting
[Before starting, let me point to a very interesting new working paper at Mercatus, by Robert Hetzel. He was somehow able to preserve his monetarist perspective while working for decades at the Richmond Fed. Lots of interesting discussion of how the Fed needs to make the rate setting process clearer. In addition, I have a new piece on the Fed, at The Hill.]
Given that the past 10 years have seen a pretty boring recovery, how can I be sure that the next 3 years will be interesting? Because one of three things must happen:
1. A dramatic change inflation, to a rate far from 2%
2. A recession
3. Continued growth with 1% to 3% inflation
The first two are obviously interesting. But why the third?
It turns out that the US has never had a soft landing. Other countries have, but not us. We’ve never had three years of low inflation growth once unemployment fell to cyclical lows.
Consider the following claims:
1. Inverted yield curves predict recessions. (True)
2. Tight money causes recessions. (True)
3. Inverted yield curves show that money is too tight. (False)
It would seem like if the first two claims were correct, then the third claim would also be true. But that’s not the case.
The 3 month/10 year yield spread inverted slightly in September 1966, May 1989, September 1998 and January 2006. In 2 of those 4 cases a recession occurred within two years. But in none of those 4 cases was monetary policy clearly too contractionary at the time. Even in May 1989 and January 2006, the actual policy mistakes occurred a year or more later.
Today the inverted yield curve shows that there is a heightened risk of recession. That’s true. But that doesn’t necessarily mean that money is too tight.
Nonetheless, monetary policy is slightly too tight, as a bit easier money would help reduce the risk of recession without causing inflation to overshoot the 2% target. Policy is not far off course, but it is a bit too tight.
On balance, I believe the most likely outcome over the next three years is a soft landing, although the risk of recession is probably at least 30%. I view the risk of high inflation as being well under 10%.
This rather optimistic take is based on several factors:
1. Previous recessions were often triggered by tight money policies aimed at restraining inflation. I see little risk that the Fed will adopt tight money for that reason. It might adopt tight money for some other reason, like inertia in adjusting the policy rate to the fast moving equilibrium rate.
2. It seems to me that we are nearing a major turning point in the zeitgeist. Policy was dovish in the 1960s and 1970s, because people thought dovish policy was appropriate. That view gradually became discredited, and then policy became hawkish in the 1980s. The hawkish era now seems to be ending, partly because the recent predictions of the doves have been consistently more accurate. Over time, the hawkish warnings about inflation get tuned out, especially by the younger generation.
James Bullard’s recent dissent is a straw in the wind. Bullard has taken both dovish and hawkish stances at various points in time. His recent advocacy of policy easing is one indication that this view is ascendant.
These changes in the zeitgeist are associated with changes in policy, with a lag. The easy money of the 1960s came several years after President Kennedy called for faster growth, and the tight money of the 1980s came several years after Volcker was appointed. While monetary policy is inertial, when it turns the new trend often lasts for decades. I’d expect the next few decades to feature a Fed bias towards dovishness.
I also believe that the Fed learns something from its mistakes. After WWII, they did not repeat the errors of the post-WWI period. After the 1970s, they did not repeat the mistakes of the Great Inflation. I suspect that the Fed has learned some lessons from the Great Recession. They won’t formally adopt NGDPLT, but they will quietly try to make sure that NGDP follows a path that is not too far from what NGDPLT would call for. (Just as inflation targeting was adopted informally, long before it was adopted formally.) Deep down they probably understand that NGDPLT would have done better in 2008-09. Again, Bullard is ahead of the curve.
The biggest risk of recession comes from a “shock”. In the past I’ve argued that the housing/banking shock of 2008 did not cause the Great Recession; tight money was to blame. At the same time, it’s clear that the tight money error would have been much less likely to occur if we had never had a financial crisis. In this case I see two possible shocks that might cause the Fed to screw up:
1. A Eurozone crisis, probably triggered by Italy leaving the Eurozone.
2. A major trade war (which I do not expect to occur.)
I suppose a war with Iran might qualify, but I have trouble seeing how that could trigger a recession. They no longer export much oil.
Brexit is also a possible flashpoint. Ironically, I believe the biggest risk here is that Brexit goes well. If it is seen as going well, it might encourage the Italians to leave. That would probably destroy the euro. I just can’t see how the other weaker Eurozone members could withstand a run on their financial systems if Italy left. In the long run, Europe might be better off without the euro. But as we saw in 1931, the short run impact is contractionary when one country leaves this sort of regime.
Thus Macron will be very tough with Boris, pour encourager les autres.
PS. The current ruling party in Italy was founded by a clown. The new Ukrainian leader is a comedian. And now another clown looks set to become the new British PM.
And let’s not even talk about the USA . . .
As Marx said; history repeats itself, the first time as tragedy, the second time as farce. I’m sure glad to be living in the farce era.
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25. June 2019 at 11:06
It’s difficult to make predictions, especially about the future. But Sumner does his usual, thorough job of it. I too believe a “shock” to be the biggest risk, but I can’t help but notice that a financial crisis per se is not one of the potential “shocks” listed by Sumner. I assume that’s because financial crises don’t just happen, but are caused by other events and actions (war, tight money, etc.). A review of history reveals a tight correlation between high levels of inequality and financial crises (e.g., 1929, 2007). Sumner would say that it was the tight money, stupid (to borrow a phrase). As asset prices continue to climb, and ever more speculative assets hit the markets, one has to be more than cautious. The big problem for the Fed is that taming asset prices is highly unpopular (ask Trump) and is counterintuitive in today’s low “inflation” environment.
The big question is what will the Fed and government do in the event of another financial crisis, will they intervene and stop the fall in prices or will they let prices fall (the latter being the preferred “solution” of the Austrians). If financial crises become recurring, is it even possible for the Fed and government to intervene “successfully” every time?
25. June 2019 at 11:13
Since you mentioned Bullard, it’s interesting to note the market’s reaction this afternoon to his comment (around 12:30) ruling out a 50 bps cut in July. Stocks down, dollar up, rates down, gold down, oil down.
25. June 2019 at 11:27
Excellent post. I do think the Fed learns over time, slowly, and I think they can pull off a soft landing here.
The Hill article was even better. NGDPLT still feels a wee bit on the wonky side, whereas targeting inflation over a longer period feels like an incremental move from current policy, and hence more doable.
25. June 2019 at 11:31
@Garrett, this is disappointing coming from Bullard. The bond market has already absorbed the 0.25% cut to come (1-month at 2.10%, 10-year at 1.99%), so ruling out a 50 bp cut in July guarantees the Fed remains a bit behind the curve for the time being.
But who knows? Maybe we get a positive surprise on 2nd quarter GDP or July employment or something.
25. June 2019 at 12:05
”Policy is not far off course, but it is a bit too tight.” Unfortunately, you have confused me about your use of such terms as ‘too easy’ and ‘too tight’. Sometimes it seems you are comparing the monetary authority’s setting of the money supply with the setting that would be required to produce your desired level of medium-term-expected NGDP—for the U.S., a level lying along a trajectory of 4% or 5% growth per annum (beginning with some not-very-well specified time in the fairly recent past). But then on the contrary you suggest that the proper benchmark (in the U.S.) is the Fed’s statutory mandate—the setting of the money supply that would produce “stable prices” (interpreted as 2% PCE inflation) and “full employment” (interpreted as . . . well, that seems rather fluid!). These won’t usually differ much, but in theory they can be quite divergent. For clarity’s sake, I think you should always have adhered to the first interpretation.
25. June 2019 at 13:03
It seems like your point #1 is key. Using rate targeting as the policy tool and developing inertia regarding that tool means that it is somewhat likely that slight and manageable shifts to a contractionary policy stance might nudge the neutral rate lower & lead to policy errors down the line.
25. June 2019 at 13:08
Garrett, Good point. I guess everything’s relative. Bullard is more dovish than the median Fed member, but perhaps less dovish than the market.
Philo, In almost every case, my judgments about policy apply under either criteria. The Fed needs to produce stable monetary policy, so that’s ultimately the benchmark. If they want 2% inflation, they need to be judged based on that goal.
25. June 2019 at 13:10
Kevin, I agree.
25. June 2019 at 15:24
3. Continued growth with 1% to 3% inflation—Scott Sumner
This would be a fascinating outcome if we actually saw 3% inflation.
The Bank of Japan, the ECB, and the Fed all target 2% inflation. In none of these monetary regimes is the inflation target reached and in all economic growth is sluggish. Persistently!
Institutional investors are buying 10-year German bonds at negative interest rates. I will take that as a clue that monetary policy has been tight.
25. June 2019 at 19:23
Add on:
Okay, lately I have accused of being “insane” or an “idiot,” so I will pose this question as timidly as possible, and first I will take off my tin-foil hat.
I very contritely wish to address the topic of “the inverted yield curve.”
1. Okay, lots of macroeconomists say “the market determines long-term rates, not the central bank.” (In general–sure if a central bank goes bananas, you can get higher long-term rates, and if a central bank is chronically easy to tight, you will affect long-term rates).
2. OK, but the Fed is paying interest on excess reserves, and conducting repo programs to keep short-term rates at somewhere around 2.35%.
3. Is the Fed holding short-term rates “artificially high”? How come no one ever writes this? If the market says 10-year Treasuries should pay 2.05%, then shouldn’t short-term rates be near zero? Is this action by the Fed causing an artificial inverted yield curve (or flat curve)?
4. Should the Fed go to zero on IOER? Why not?
5. Is the Fed a “captured regulatory agency”? The banks like IOER.
Okay, I am putting back on my tin-foil hat.
26. June 2019 at 04:07
Iran has the means to disrupt all shipping through the straits.
(Where can I find a statement of your position on the EU and on the Euro?)
26. June 2019 at 07:23
I use the Marx quote—I find it funny. It was the opening two sentences of his anti-Louis Napoleon essay mocking his coup of 1851 “the 18th Brumaire of Louis Bonaparte”—-comparing when Napoleon in 1799 staged his coup (the so-called “18th Brumaire”–i.e. date on the French Calendar corresponding to November something or other in 1799). The full quote is “Hegel remarks somewhere
that all great world-historic facts and personages appear, so to speak, twice. He forgot to add: the first time as tragedy, the second time as farce”. Who says Marxists cannot be funny?
Re: your essay. I find it hopeful (or perhaps you are losing your touch) you do not believe the Fed will once again repeat its seeming inability to not tighten when all signs point otherwise. I think shocks cause all to panic (one of my favorite books is Bruner and Carr’s “The Panic of 1907”) and lose judgment.
I agree on the inadvisability of the Euro—-but I am starting to believe that horse is so far out of the barn it can never return. Talk about tragedy and farce, what a joke it would be if Italy got the ball rolling (although in that case Marx’s dictum would be reversed) by leaving. England at least had its own debt—these southern men have Germany’s. If I were the crown prince of Europe, I would begin now by loosening the reigns on their pan-European restrictions with a long term goal of dissolving the Euro. But that won’t happen. My usual use of the Marx quote refers to Germany taking over Europe—first time as a tragedy–second time as farce.
26. June 2019 at 11:14
Ewan, I support the EU, but think it’s gone way too far in micromanaging regulations in individual countries.
The euro was a mistake, but it’s very hard to disentangle it now. The best thing they could do at the moment is to have the ECB adopt a 4% NGDPLT policy, and give them the authority to do whatever it takes to hit the target.
Michael, I said there is a 30% risk or recession, so I am not at all confident that the Fed will react appropriately.
26. June 2019 at 14:13
Why think the EU a Good Thing?
And please don’t think attacking Iran no big deal!
26. June 2019 at 16:36
Ewan, I think attacking Iran would be a MASSIVE mistake. I never said it would be no big deal. If I do not say something, then please don’t assume I think it.
Why is the EU a good thing? Start by comparing European history before and after 1957.
Then think about the fact that it’s a huge free trade zone, and that EU workers are free to work in any of the EU countries. That’s a big gain for both freedom and economic efficiency. Some former dictatorships became democratic partly so that they could join the EU, so there are political advantages as well.
27. June 2019 at 13:00
I’m sorry, but this read as a tad flippant or insouciant: “I suppose a war with Iran might qualify, but I have trouble seeing how that could trigger a recession. They no longer export much oil.” I read it wrong. By the way, not a “mistake” – I think, technically, a crime.
That the EU kept the peace where before there was war is a misconception. What kept the peace was the Cold War. The US and USSR called the shots. The Europeans did what they were told. The idea of them waging war without their masters’ approval is laughable.
The EU “project” has always been about ever closer integration, not economic efficiency, and not democracy. The “project” has been pushed forward regardless of what people think – any time they vote against, they are required to vote again until they get it right, or the policy is introduced anyway under a different name.
Free trade (or whatever it is the EU does) and free movement of labour do not require the EU “project” of ever closer integration i.e. political union – do they? (And, as it happens, a large proportion of Europe’s youth would be happy to exercise their “freedom” to work, if only saving the banks and the Euro hadn’t proved to require – apparently – so much sacrifice by so many.)
So the question remains, why is the EU a Good Thing? That isn’t meant to be as rhetorical as it sounds.
27. June 2019 at 14:02
Scott,
The economy was doing pretty good from 1945-1957, not to say it did great. The Wirtschaftswunder in Germany, Les Trente Glorieuses in France and Il Miracolo Economico in Italy, most of that seems to have happened before 1957. And then the boom ended a few years later.
EU a peace project? Just another myth, not to say fake news. The role of the EU as a peace project is overrated.
The list goes on. Lots of myths and wishful thinking.
If you don’t believe me read Kiran Klaus Patel as a start. The history of the EU is his specialty, he holds the Jean Monnet Chair in Maastricht. He is not against the EU per se, but he says that we should be honest about it.
NATO was fine, the common market was fine, but all the rest looks overdone. They meant well, but that’s about it.
Today, the EU is a source of never-ending disputes.
28. June 2019 at 09:50
Ewan, I said “MASSIVE mistake” and you reported me saying a mere “mistake”. Ok, so if that’s the way you want to be then I’ll take that into account in future responses.
As for the rest, I already said I opposed the excessive integration, a comment you chose to ignore. Keep beating your dead horses.
28. June 2019 at 12:49
Where’s the massive mistake? How can you be so sure, are you a visonary? The Iranian mullah regime is the root of nearly all evil in this region. The US should have eliminated them long time ago. Maybe better late than never. Maybe better now than never.
29. June 2019 at 06:47
Prof. Sumner
I’ve riled you!
On “mistake”: I apologised for misreading the tone of your comment. I then pointed out that “mistake” (not “massive”) was, well, a mistake. A war of aggression against Iran is a crime.
On the EU, my question was perfectly ingenuous: are the benefits you adduce not attainable without the EU? I genuinely want to know the arguments for persisting with the EU. There is the Varoufakis argument for reform from within, but I remember Mr. Brown encouraging us to stick with the EU to reform it from within – that went well. Is it just that we are so far in that to go back would be too expensive?
What is the positive case for the EU?
It was not my intention to mistake either the tone or content of your comments. I genuinely wanted to know your thoughts.
29. June 2019 at 06:52
Christian List
“The Iranian mullah regime is the root of nearly all evil in this region.”
I’ve blundered about so far mistaking people’s meaning. Do you intend this as sarcasm? Iran? Not the US, or the Saudis, or Israel? Are you using some special definition of “evil”? I would have thought fomenting and fighting wars would count.