Must-Read: Lawrence Summers: The Fed’s Complacency About Its Current Toolbox Is Unwarranted

Must-Read: Larry Summers is right: forward guidance and large-scale QE are unlikely to be powerful enough tools for the Fed to deal with the next recession. This is especially true given the Fed’s current policy posture. Large-scale QE is, I believe, primarily useful as a signal of forward guidance. And the Federal Reserve’s current eagerness to tighten monetary policy without any visible signals of an overheating high pressure economy is greatly undermining its ability to credibly engage in forward guidance in the future:

Lawrence Summers: The Fed’s Complacency About Its Current Toolbox Is Unwarranted:

I was disappointed in what came out of Jackson Hole for three reasons…

The Fed should have signaled a desire to exceed its two percent inflation target during periods of protracted recovery and low unemployment…. Even apart from the desirability of allowing inflation to rise above two percent in a happy economic scenario GDP, labor market and inflation expectations data all make a compelling case against a rate increase….

My second reason for disappointment… was that Chair Yellen… was too complacent to conclude that:

even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively.

This statement may rank with Ben Bernanke’s unfortunate observation that subprime problems would be easily contained. Rather I believe that countering the next recession is the major monetary policy challenge before the Fed…. It is more than 50 percent likely that we will have a recession in the next 3 years. Countering recessions requires 400 or 500 basis points of monetary easing. We are very unlikely to have anything like that much room for easing when the next recession comes.

Chair Yellen, relying… on… David Reifschneider using the FRBUS model, comes to the relatively serene conclusion that by using forward guidance and QE… the Fed will likely able to respond adequately to the next recession with its existing tool kit.  I think this conclusion is unlikely to be right…. There is an important methodological point here: distrust conclusions reached primarily on the basis of model results.  Models are estimated or parameterized on the basis of historical data.  They can be expected to go wrong whenever the world changes in important ways.  Alan Greenspan was importantly right when he ignored models and maintained easy policy in the mid 1990s because of other more anecdotal evidence that convinced him that productivity growth had accelerated. I believe a similar skeptical attitude towards model results is appropriate today….

I wonder what credibility Fed forward guidance is likely to have given the utter disconnect over many years between Fed and market views regarding future rate and the track record so far of the Fed being wrong and the market being right…. Even if unconventional policy could be highly efficacious in moving long term rates and even if QE induced moves in long rates were potent, there is the question of how much room there is to bring down long rates. Reifschneider… shows that with a big recession rates would likely approach -6 percent, or even -9 percent, but for the zero lower bound.  I find the idea that forward guidance and QE could do the anything like the work of 600, let alone 900, basis points of rate cutting close to absurd…