Must-Read: Lawrence Summers: 5 reasons the Fed may be making a mistake

Must-Read: Lawrence Summers: 5 reasons the Fed may be making a mistake “The… paradigm… is highly problematic.  Much better would be a “shoot only when you see the whites of the eyes of inflation” paradigm…

…more credible, more likely to result in the Fed’s satisfying its dual mandate, reduce risks of recession, and increase the economy’s resilience when recession comes. Many of my friends have recently issued a statement asserting that the Fed should change its inflation target…. I think that this issue is logically subsequent to the question of how policy should be made in the near term with the given 2 percent inflation target…. First, the Fed is not credible with the markets…. Markets do not share the Fed’s view that inflation acceleration is a major risk.  Indeed they do not believe the Fed will attain its 2 percent inflation target for a long time to come….Second, the Fed regularly proclaims that it has a symmetric commitment…. So why would the Fed want to be projecting only 2 percent inflation entering the 11th year of recovery with an unemployment rate clearly below their estimate of the NAIRU?… The PCE core price level is a full 4.3 percent where it would be had it risen by the Fed’s target amount over the past decade…. Policy should be set with a view to modestly raise target inflation, perhaps 2.3 or even 2.5 percent inflation, during a boom with the expectation that inflation will decline during the next recession…. Third… we have little ability to judge when inflation will accelerate in a major way. The Phillips curve is at most barely present in data for the past 25 years. And as Staiger, Stock and Watson demonstrated years ago, the NAIRU, assuming such a thing exists, can only be estimated with extreme imprecision…. In recent months both overall and core inflation have come down along with market and survey measures of inflation expectations… contrary to all the Fed staff models….

Fourth… there is good reason to believe that a given level of rates is much less expansionary than it used to be given the structural forces operating to raise saving propensities and reduce investment propensities. I am not sure that a 2 percent funds rate is especially expansionary in the current environment…. Fifth, a “whites of their eyes” paradigm… require[s] the Fed… simply needs to assert that its objective is to assure that inflation averages 2 percent over long periods of time… inflation is… very difficult to forecast… focus on inflation and inflation expectations data rather than measures of output and employment in forecasting inflation. With these principles internalized, the Fed would lower its interest-rate forecasts to those of the market and be more credible. It would allow inflation to get closer to target and give employment and output more room to run…


Brad DeLong
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