What Is the Eccles Building Thinking Today? II: The Reasonable People Are Very Unreasonable Indeed

Larry Summers: What Should the Fed Do and Have Done?: “The Federal Reserve… has strongly signaled that it will raise rates…

…Given the strength of the signals that have been sent it would be credibility-destroying not to carry through with the rate increase, so there is no interesting discussion to be had about what should be done on Wednesday…

This seems to me to be wrong: credibility that one will stubbornly pursue bad policies is not worth gaining, or preserving.

If the FOMC were to end today’s discussion convinced that on balance it would be a mistake to raise interest rates right now, the right communique would be: “While we entered this meeting believing that raising interest rates was appropriate, we find–to our surprise–that today’s discussion has changed our minds.”

If–as is more likely than not–they will in the future wish that they had backed off their policy and surprised markets with lower interest rates, better to have the smaller surprise sooner than the bigger surprise later.

Larry continues:

But was it right to move at this juncture? This requires weighing relative risks. A decision to keep rates at zero would have…risk[ed] an overheating economy and an acceleration of inflation, possibly necessitating a sharp and destabilizing hike in rates later… encourag[ed] financial instability, particularly if there became a perception that the Fed would never raise rates… [left] the Fed with less room to lower rates in response to problems than it would have if it increased rates. Finally, perhaps… economic actors take… zero rates as evidence that the Fed is worried and so they should be…. Some believe that… we no longer have a pathological economy and so no longer should have zero rates…. Perhaps there is a fear that when rates go up something catastrophic will happen and this source of uncertainty can only be removed by raising rates.

These arguments do not seem hugely compelling to me.

Indeed not.

Summers concludes:

An excessive delay in raising rates can be remedied eight weeks later at the next FOMC meeting by raising them then. On the other hand, if rates are raised and it proves to be a mistake… inflation expectations move down, financial turbulence… the economy… tips towards recession.  Reversing the rate increase would be unlikely to eliminate these consequences.  Moreover, reversing the direction of policy would hardly be helpful for central bank credibility…

And then comes a sentence I really do not understand:

Reasonable people can come to different judgements on all of this…

How can reasonable people come to different judgments? If the FOMC concludes that it is behind the curve on raising interest rates, it can immediately catch up. As Larry says: “An excessive delay in raising rates can be remedied eight weeks later…” If the FOMC concludes that it is ahead of the curve on raising interest rates, it cannot then recover by dropping them below zero. The asymmetry of the zero lower bound makes it unwise to start liftoff as long as there remains a material chance that the short-run neutral rate will again kiss zero in the near future. And there does remain such a material chance.

What is the reasonable person’s argument here?

December 16, 2015


Brad DeLong
Connect with us!

Explore the Equitable Growth network of experts around the country and get answers to today's most pressing questions!

Get in Touch