Must-Read Pre-Liftoff Lollapalooza: Tim Duy: Makes You Wonder What The Fed Is Thinking

Must-Read Pre-Liftoff Lollapalooza: The extremely-thoughtful Tim Duy is… genuinely frightened…

Tim Duy: Makes You Wonder What The Fed Is Thinking: “My interest tonight is a pair of Wall Street Journal articles that together call into question…

…the wisdom of the Fed’s expected decision… inflation, or lack thereof, by Josh  Zumbrun… the growing consensus among economists that the Fed faces the zero bound again in less than five years…. Fed officials expect the terminal fed funds rate in the 3.3-3.8 percent range (central tendency) while the 2001-03 easing was 5.5 percentage points and the 1990-92 easing was 5.0 percentage points. You see of course how the math works….

The policy risks are asymmetric. They can always raise rates, but the room to lower is limited by the zero bound. But that understates the asymmetry. You should also include the asymmetry of risks around the inflation forecast. The Fed has repeated under over-forecasted inflation. It seems like they should also see an asymmetry in the inflation forecast that compounds the policy response asymmetry. Asymmetries squared. Given all of these asymmetries, I would think the Fed should continue to stand pat until they understand better the inflation dynamics. The Fed thinks otherwise. Why would Federal Reserve Chair Janet Yellen allows the Fed to be pulled in such a direction? Partly to appease the Fed hawks. And then… Yellen is wedded to the theory that the sooner the Fed begins normalizing policy, the more likely the Fed can avoid a recession-inducing sharp rise in rates. She follows up this concern with: “Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.”

This is what Mark Dow calls ‘avalanche patrol’… becomes a story of a Fed caught between a world in which the policy necessary to meet their inflation target is inconsistent with financial stability…. And my sense is that Yellen feels the best way to slip through those cracks is early and gentle tightening….

The Fed likely only gets one chance to lift-off from the zero bound on a sustained basis…. They [sh]ould wait until they were absolutely sure inflation was coming. Even more so given the poor performance of their inflation forecasts. But the Fed thinks there is now more danger in waiting than moving. And so into the darkness we go.

December 15, 2015


Brad DeLong
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