Larry Summers has consistently argued against the Federal Reserve raising the interest rates it controls, and following its Dec. 16 decision to raise its targeted federal funds rate by 25 basis points, Summers now argues that the Fed actions make “secular stagnation more likely.”
In a chapter for an August 2014 ebook on secular stagnation, Summers wrote that “The ‘new secular stagnation hypothesis’ suggests that macroeconomic policy as currently structured and operated may have difficulty maintaining a posture of full employment and production at potential, and that if these goals are attained there is likely to be a price paid in terms of financial stability.”
And in a column in the Financial Times on Dec. 9, Summers wrote: “History suggests that when recession comes it is necessary to cut rates more than 300 basis points. I agree with the market that the odds are the Fed will not be able to raise rates 100 basis points a year without threatening to undermine recovery. Even if this were possible, the chances are very high that recession will come before there is room to cut rates enough to offset it. The knowledge that this is the case must surely reduce confidence and inhibit demand.”
So what is secular stagnation, and why should we care? In a blog post published today on his own site, the former Treasury secretary and Harvard president says the “core idea” of secular stagnation is that the neutral real interest rate “had for a variety of reasons fallen and might well be below zero a substantial part of the time going forward.” The result of such stagnation? “Economies might be doomed to oscillate between sluggish growth and growth like that of the 2003-2007 period that rested on an unstable financial foundation.” He says that “weaker growth despite lower real interest rates” is a confirmation of this state of secular stagnation.
Citing GDP in the developed world, Summers says that there has been weaker-than-expected growth despite low rates, suggesting a decline in demand. Referencing a speech he gave at the Bank of Chile Research Conference, Summers concludes in his blog post that “I would judge that there is at least a two-thirds chance that we will experience zero or negative rates again in the next five years.”
The Fed, Summers proposes, could have avoided creating the atmosphere for secular stagnation with “strong policy,” but instead it and “other policy setters remain committed to traditional paradigms and so are acting in ways that make secular stagnation more likely.”
Summers lists four “consequential misjudgments” that were reflected in the decision of Chair Janet Yellen and the Federal Open Market Committee to raise rates.
1. “The Fed assigns a much greater chance that we will reach 2% inflation than is suggested by most available data,” Summers says, arguing instead that “Inflation swaps suggest” that inflation will average “only 1% over the next 3 years, 1.2% over the next 5 years and 1.5% over the next 10 years.” 2. “The Fed seems to mistakenly regard 2% inflation as a ceiling, not a target,” and argues, “given the observed costs of deflation,” that “the costs of under shooting the target exceed the costs of overshooting it.”
3. The Fed “seems to be in the thrall” to the idea — unsupported by any data — that “the rate of change of interest rates as distinct from their level influences aggregate demand.” He says that the Fed’s argument that it should raise rates so it will be able to lower rates “is in the category with the argument that I should starve myself in order to have the pleasure of relieving my hunger pangs.”
4. On this “misjudgment,” Summers returns to his theme that “the Fed is likely underestimating secular stagnation…by overestimating the neutral rate,” and fails to see that “the complexity is that zero rates may be less abnormal than is supposed because of fundamental shifts in the saving investment balance.”
Why is the Fed making these misjudgments? “I suspect it is because of an excessive commitment to existing models and modes of thought,” Summers says. “Usually it takes disaster to shatter orthodoxy. We can all hope that either my worries prove misplaced or the Fed shows itself to be less in the thrall of orthodoxy than it has been of late.”
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