Must-Read: Larry Summers: Four Things the Fed Should Do Now

Must-Read: Larry Summers: Four Things the Fed Should Do Now:

The neutral rate is now close to zero and it may well remain under 2 percent for the foreseeable future…

With the economy growing at below 2 percent over the last year, total hours of work essentially flat for the last 6 months, and with long term inflation expectations declining there is no reason to think we are currently much below the neutral rate…. [The Fed] should acknowledge at least to itself that it has damaged its credibility by repeatedly  holding out the prospects of much more tightening than the market anticipated, being ignored by the market, and then having the market turn out to be right. It should recognize output and inflation and unemployment would all be closer to their target levels today and in their forecasts if rates had not been increased last December. It should move to bring its stated plans more in line with external expectations regarding how much tightening the economy can tolerate….

The Fed should make real the idea that its inflation target is symmetric…. It should be clear that until inflation expectations look to be rising above 2 percent there is no need to restrain the economy…. The Fed should make clear that it sees risk as asymmetric right now.  If the economy falls into recession there is a real risk of a Japan scenario…. There is no great risk if inflation drifts above two percent. It might, as I have noted, actually be desirable. And if not, policy can be tightened to prevent the economy from overheating as has occurred many times in the past.

Eric Rosengren, in explaining his dissent on the decision not to raise rates in September, argues that the Fed has historically had a hard time tapping the brakes and that if the Fed has to cool off an overheated economy a recession is likely to result. I am not sure what aspect of history he has in mind here…. On occasion… recession was the price of bringing it back to desired levels.  Rosengren’s case would be made by examples where so much extra slack was induced that the economy undershot on inflation. I am not aware of such instances…. It takes a tortured argument to believe that you can prevent a car from stopping by hitting the brakes…