Speaking of too little and too late, Lawrence Summers expresses considerable dissatisfaction with the moves the Federal Reserve Open Market Committee took yesterday in an op-ed in the Washington Post:
The stock market responded positively Wednesday to the Federal Reserve’s move to raise interest rates and plan for six more increases by year’s end. I wish I could share that enthusiasm. Instead, I fear, the economic projections of the Federal Open Market Committee (FOMC) represent a continuation of its wishful and delusional thinking of the recent past.
Start with the labor market. It is now tighter than at any point in history: the vacancy-to-unemployment ratio is in unprecedented territory, quits are at near-record levels and wage growth is still rising at 6 percent, having accelerated rapidly in the past few months. The FOMC expects further tightening, to a 3.5 percent unemployment rate, which it expects will be maintained through 2024.
Three years at 3.5 percent unemployment, something the country has not seen in about 60 years, is highly implausible. Indeed, the historical experience is that when unemployment is below 4 percent, there is a 70 percent chance of joblessness rising rapidly in the next two years as the economy goes into recession.
But that is not the central absurdity in the Fed forecast. The chief problem is the idea that a super-tight labor market will somehow coincide with rapidly slowing inflation. Even on the Fed’s optimistic accounting, a balanced economy requires 4 percent unemployment, meaning that it expects the labor market will remain abnormally tight over the next few years.
Data on vacancies and tightness reinforce the case that such conditions are inflationary, not disinflationary. Wages represent by far the largest component of costs. When they are rising so fast, what basis is there for supposing that inflation will slow to the 2 percent range foreseen by the Fed?
Focusing on the tightness of labor markets as a basis for forecasting inflation is firmly within progressive Keynesian tradition. Many economists look, as Milton Friedman and Paul Volcker did, to measures of money supply or projected government debt for guidance on inflation. These indicators are much more alarming.
A look at the Fed’s forecast revisions since December reveals its confused thinking. The central principle of anti-inflationary monetary policy is that to reduce inflation it is necessary to raise real rates. Equivalently, it is necessary to raise interest rates by more than the inflation being counteracted and above a neutral level that neither speeds nor slows growth. I had thought this was universally accepted following the work of former George W. Bush administration official John Taylor and former Obama administration Council of Economic Advisers chair Christina Romer and her husband, David Romer.
Yet because of upward revisions in the inflation forecast, the Fed’s predicted real rates have actually declined in recent months. In other words, the FOMC’s plans do not even call for keeping up with the rising inflationary gap. It is hard to see how interest rates that even three years from now will be about 2 percentage points less than current rates of inflation can reasonably be regarded as providing sufficient restraint.
“Delusional” is pretty strong language. The editors of the Wall Street Journal are in material agreement with him:
The Fed’s action Wednesday to raise the fed funds rates by 25 basis points was modest and expected. The surprise was in the forecast for the next two years. In December the median prediction of Fed governors and bank presidents was four 25-point increases by the end of this year. Now it’s seven, plus another four rate hikes in 2023.
The Fed also climbed down from the fence on when to start shrinking the $9 trillion balance sheet it has built up to ease financial conditions. The FOMC says it will begin to reduce its holdings of Treasurys and mortgage-backed securities “at a coming meeting.†This sounds like sooner rather than later. This “quantitative tightening†is long overdue, and inflation might be much lower than it is had the Fed started doing this a year ago.
The Fed’s problem is that it has already let inflation run free, as the governors and bank presidents all but admit. They are now forecasting an inflation rate this year of 4.3%, a leap from 2.6% only three months ago. That’s the rate of so-called personal-consumption expenditure (PCE) inflation, which is the Fed’s preferred measure and is lower than the consumer-price index. PCE inflation was 0.6% in January alone, so it will have to slow considerably in the rest of the year to meet the Fed’s 4.3% estimate for 2022. Good luck.
Even with the 11 25-point rate hikes anticipated by the Fed, the fed-funds interest rate would be only 2.8% at the end of 2023. That would still be lower than the likely inflation rate, which means real rates would be negative for all of 2022 and 2023. The long experience of monetary policy is that inflation doesn’t fall until interest rates exceed the inflation rate. There’s no reason to expect this time would be an exception, barring a recession.
Mister, we could use a man like Paul Volcker again. If inflation were reckoned the way it was in 1980, today’s inflation rate would be just about what it was in 1980. Paul Volcker started raising the fed funds rate shortly after he became Fed chairman in 1979 and was probably as important as any other man for Ronald Reagan’s landslide victory in the presidential election of 1980. It sounds to me like Jerome Powell wants to avoid a recapitulation of that.
I’m not the first person to say it but despite Joe Biden’s aspirations to be the second coming of FDR it will take considerable good fortune for him to avoid being the second coming of Jimmy Carter.
Meanwhile both the FOMC and its critics are making an increasingly convincing argument for replacing the committee with an algorithm. If its members have any desire to avoid that, they need to start showing some spine.
As a complete layman on these matters, Summer’s critique sounds convincing to me. I would just add – why has it taken so long to raise rates? It’s like letting half the house catch on fire before turning on the hose.
Replacing the committee with an algorithm is tantamount to saying to go back to pre-Bretton Woods gold standard.
The point of fiat is to have the discretionary ability to adjust the cost of money.
Now I agree the FOMC has been discrediting itself. If it keeps to its current course the next chair could be someone from well outside the “mainstream”; like Judy Shelton.
The most plausible explanation for the Fed’s lateness was the Fed believed what it was saying — “it was transitory”. Also, lack of institutional fear of inflation; the pervasive belief the problem was disinflation or deflation (recall they raised their inflation target from a ceiling of 2% to a 2% average, the mania around MMT).