Someone has finally used the word "absurd" in reference to the Federal Reserve’s policy of gradual interest-rate hikes to combat inflation as the year-on-year consumer price index is about to cross the 8% threshold.
You can say what you like about Larry Summers, but the former Treasury secretary and director of the National Economic Council, who spends most of his time at Harvard when not in office, is a smart economist.
He had this to say about the Fed’s apparent plan, after mocking policymakers’ projection of three years of 3.5% unemployment as something not seen in about 60 years and "highly implausible:"
"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."
This is a stretch even in the Keynesian tradition that Fed economists use, making labor markets the basis for forecasting inflation. But in a monetarist framework, Summers writes in the Washington Post, you have to raise real rates to reduce inflation.
However, the Fed’s gentle, gradual plan to raise rates by a quarter-point in successive meetings of the Federal Open Market Committee actually results in a decline in real interest rates—that is, the nominal rate minus inflation. As Summers wrote:
"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."
Even ahead of last week’s FOMC meeting, Summers had warned that the Fed was on the wrong track with its plan to raise rates only a quarter-point.
"I believe the Fed has not internalized the magnitude of its errors over the past year, is operating with an inappropriate and dangerous framework, and needs to take far stronger action to support price stability than appears likely."
The consequences, in his view, are years of stagflation with 5% inflation and 5% unemployment, ending eventually in a recession. Real rates need to reach 2 or 3%, which would mean nominal rates of 5% or more even in a best-case scenario, according to Summers.
St. Louis Fed chief James Bullard dissented from the FOMC vote for a quarter-point hike last week, arguing that a half-point hike would have been a better choice given the high inflation rate. Even with the Fed’s conservative benchmark—core inflation on the personal consumption expenditure index stripping out food and energy costs—annual inflation is 5.2%, 320 basis points above the 2% target.
Bullard is urging a policy rate of above 3% by the end of this year for overnight fed funds, instead of the 1.875% rate projected by the committee as a whole.
“US monetary policy has been unwittingly easing further because inflation has risen sharply while the policy rate has remained very low, pushing short-term real interest rates lower. The committee will have to move quickly to address this situation or risk losing credibility on its inflation target,” Bullard said in a statement explaining his dissent.
That should probably be in the past tense—the Fed has already lost a lot of credibility.
Bullard believes the US economy is resilient enough to sustain this kind of hike in interest rates. However, Bill Gross, the former asset manager at Pimco, who made a fortune for himself and many others by navigating interest rates in his massive bond fund, has a different view. In an interview with the Financial Times, Gross explained:
"I suspect you can’t get above 2.5 to 3% before you crack the economy again. We’ve just gotten used to lower and lower rates and anything much higher will break the housing market."
Even the cautious members of the FOMC are projecting a 2.8% overnight interest rate by the end of 2023, so Gross’s forecast does not leave them much room for maneuver.
Powell's Legacy On The Line?
The US Senate flexed its muscles last week and killed the nomination of Sarah Bloom Raskin to be Fed vice chair for supervision. West Virginia Democrat Joe Manchin came out against confirming her because of her outspoken position that US banks should cut off support for fossil fuel companies. With all Republicans opposed, the single Democratic defection tipped the scale in the 50-50 Senate.
Even though Raskin, who had won the Senate’s nod twice before for posts at the Fed and the Treasury, said at her most recent confirmation hearing that she would not enforce that view in her new position, opponents weren’t buying it.
Ironically, her withdrawal from consideration freed the Senate Banking Committee, which Republicans had boycotted on her account, to vote on the other four pending Fed nominations, including that of Chairman Jerome Powell for a second term.
The Senate is not likely to deny Powell that second term, but his legacy is on the line. If Summers and Bullard and like-minded economists are right, history will not be kind to Powell.