Must-read: Gavyn Davies: “Splits in the Keynesian Camp: a Galilean Dialogue”

Must-Read: Very nice. But why “Galilean”, Gavyn? I do note that in the end Gavyn’s “insider” argument boils down to “we must keep the hawks on the FOMC on board with policy”, which is a declaration that:

  1. The Obama administration has made truly serious mistakes in speed of action and in personnel in its Fed governor nominations;
  2. The Bernanke-Yellen Board of Governors has made truly serious mistakes in Fed Bank President selection; and
  3. The high priority given to keeping (nearly) the entire FOMC on board with the policy path should, perhaps, be revisited.

Also, “we have already allowed for these asymmetrical risks by holding interest rates below those suggested by the Taylor Rule for a long time” is simply incoherent: sunk costs do not matter for future actions.

The dialogue:

Gavyn Davies: Splits in the Keynesian Camp: a Galilean Dialogue: “As Paul Krugman pointed out a year ago…

…a sharp difference of views about US monetary policy has developed between two camps of Keynesians who normally agree about almost everything. What makes this interesting is that, in this division of opinion, the fault line often seems to be determined by the professional location of the economists concerned. Those outside the Federal Reserve (eg Lawrence Summers, Paul Krugman, Brad DeLong) tend to adopt a strongly dovish view, while those inside the central bank (eg Janet Yellen, Stanley Fischer, William Dudley, John Williams) have lately taken a more hawkish line about the need to ‘normalise’ the level of interest rates [1]. My colleague David Blake suggested that this blog should carry a Galilean ‘Dialogue’ between representatives of the two camps. Galileo is unavailable this week, but here goes”

Fed Insider: The US has now reached full employment and the labour market remains firm. The Phillips Curve still exists, so wage inflation is headed higher. Core inflation is not far below the Fed’s 2 per cent target. While the economy is therefore close to normal, interest rates are far below normal, so there should be a predisposition to tighten monetary conditions gradually from here. That would still leave monetary policy far more accommodative than normal for a long period of time.

Fed Outsider: I am not so sure about the Phillips Curve. It seems much flatter than it was in earlier decades. But in any case you do not seem to have noticed that the economy is slowing down. This is probably because of the increase in the dollar, which has tightened monetary conditions much more than the Fed intended. The Fed should not make this slowdown worse by raising domestic interest rates as well.

Insider: I concede that the economy has slowed, and I am worried about the tightening in financial conditions caused by the dollar. But I think that this will prove temporary. The dollar effect will not get much worse from here, and the economy has also been affected by inventory shedding and the drop in shale oil investment. As these effects subside, GDP growth will return to above 2 per cent. The pace of employment growth may slow, but remember that payrolls need to grow by under 100,000 per month to keep unemployment constant at the natural rate. Some slowdown is not only inevitable, it is desirable.

Outsider: I do not know how you can be so confident that growth will recover. All your forecasts for growth in recent years have proven far too optimistic. You should be worried that the economy is stuck in a secular stagnation trap. The equilibrium real interest rate is lower than the actual rate of interest. To emerge from secular stagnation, the Fed should be cutting interest rates, not raising them.

Insider: The case for secular stagnation is a bit extreme. Economies tend to return to equilibrium after shocks. The US has been held back by a series of major headwinds since 2009, but these are now abating. Fiscal policy is easing, the euro shock is healing and deleveraging is ending. As these headwinds abate, the equilibrium real rate of interest will return to its normal level around 1.5 per cent, so the nominal Fed funds rate should be 3.5 per cent. It is right to warn people now that this is likely to happen.

Outsider: The hawkish forward guidance shown in your ‘dot plot’ will slow demand growth further. It is unnecessary – in fact, outright damaging. I am pleased that you are rethinking the presentation of the dots. But, more important, the economic recovery is already long in the tooth. There is a 60 percent chance of a recession within 2 years. In a normal recession, the Fed has to cut interest rates by 4 percentage points. Because of the zero lower bound, it will not be able to do so in the next recession, so it needs to avoid a recession at all costs.

Insider: Oh dear. Recoveries do not die of old age, as Glenn Rudebusch at the San Francisco Fed has just conclusively proved. Expansions, like Peter Pan, do not grow old. Provided that we avoid a build up of inflation pressures, or excessive risk taking in markets, there is no reason to believe that this recovery will spontaneously run out of steam. It is much more likely to persist.

Outsider: Maybe, but have you ever considered the possibility that you might be wrong? The future path of the equilibrium interest rate is subject to huge uncertainty, as your own estimations demonstrate. If you kill this recovery, it will subsequently be impossible to use monetary policy to get out of recession. If, on the other hand, you allow inflation to rise, you can easily bring it back under control, simply by raising interest rates. So the risks are not symmetrical.

Insider: Well, we have already allowed for these asymmetrical risks by holding interest rates below those suggested by the Taylor Rule for a long time. And anyway I do not agree with you about inflation risks. If we allow inflation to become embedded in the system, we will then have to raise interest rates abruptly. That is the most likely way that this recovery can end in a severe recession.

Outsider: Inflation cannot rise permanently unless inflation expectations rise as well. In case you have not noticed, inflation expectations have been falling and are now out of line with your 2 per cent inflation target. This is dangerous because real (inflation adjusted) interest rates are actually rising when they should be falling.

Insider: I used to worry a lot about the inflation expectations built into the bond market, but I now think that these are affected by market imperfections that should be downplayed. Inflation expectations in the household and corporate sectors are still broadly in line with the Fed target. And, anyway, I am increasingly concerned that inflation could rise because productivity growth is now so low. With the economy at full employment, inflation pressures could be building, even with GDP growth still very subdued.

Outsider: I am also very worried about the slowdown in productivity growth. But I think this could be happening because you have allowed the actual GDP growth rate to be so low for so long. Because of hysteresis, you may be making things progressively worse. You may have permanently shifted the equilibrium of the economy in a bad direction.

Insider: I am not so sure about this hysteresis stuff. I would not rule it out entirely. But you cannot rely on the Fed to solve all of our economic problems. At the moment, the Fed’s main priority is to return monetary policy to normal, and I am determined to continue this process unless something really bad happens to the economy.

Outsider: In that case, something bad is quite likely to happen. It seems that it will take a disaster to shake your orthodoxy. Do you really want to be responsible for making a historic economic mistake?

Insider: It is easy for you on the outside to make dramatic points like that. If you had been entrusted with the responsibility of office, you would be more circumspect. Although we went to the same graduate school, we are now in different positions. The hawks on the FOMC need to be kept on board with the majority. And I do not want to inflame the Fed’s Republican critics in Congress by appearing soft on inflation. That means I sometimes have to make difficult compromises that you do not have to make.

Outsider: The hawks are giving too much weight to the health of the banks. You should be worrying more about Main Street, and less about Wall Street.

February 21, 2016


Brad DeLong
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