Both Paul Krugman and Ryan Avent are pushing back on the Federal Reserve's apparent intent to raise rates in the middle of next year. Why is the Fed heading in this direction? Krugman offers this explanation:
My guess — and it’s only that — is that they have, maybe without knowing it, been bludgeoned into submission by the constant attacks on easy money. Every day the financial press, many of the blogs, cable financial news, etc, are full of people warning that the Fed’s low-rate policy is distorting markets, building up inflationary pressure, endangering financials stability. Hard-money arguments, no matter how ludicrous, get respectful attention; condemnations of the Fed are constant. If I were a Fed official, I suspect that I would often find myself wishing that the bludgeoning would just stop, at least for a while — and perhaps begin looking for an opportunity to prove that I’m not an inflationary money-printer, that I can take away punchbowls too.
I don't think that the Fed is reacting to external criticism. What I think is that there are two basic views of the world. In one view, the post-2007 malaise is simply the hangover from a severe financial crisis. Time heals all wounds, including this one, and the recent data suggests such healing is underway. The alternative view is that the economy is suffering from secular secular stagnation similar although not to the same extreme as Japan. The latter view suggests the need for a very low or negative real interest rates to maintain full employment, the former view suggests a fairly significant normalization of monetary policy.
I believe that the consensus view on the Fed is the former, that the malaise is simply temporary ("a temporary inconvenience") and now ending. I think this is evident from the Summary of Economic Projections - the implied equilibrium Federal Funds rate is around 3.75%. Perhaps this is below what might have been perceived as normal ten years ago, but the difference could be attributed to slower potential growth rather than secluar stagnation.
If you don't like that argument, then take the more explicit route. Gavin Davies did the intellectual legwork here so we don't have to, and catches Vice Chair Stanley Fischer saying that he doesn't believe the situation calls for protracted negative interest rates. In other words, he rejects the main monetary policy implication of the secular stagnation hypothesis.
And, I don't know if Krugman agrees, but I find it hard to believe that Fischer carries anything but extreme intellectual weight within the Fed. So I would hardly be surprised that the Fed would be moving in a direction he defined. One wonders where Fed Chair Janet Yellen's leadership is on this point? That was always a risk of adding Fischer to the Board - that what might have seemed to be a dream team turned into a power struggle.
This is not to say that I do not share Krugman's and Avent's concerns. I most certainly do. Fischer claims that markets do not believe the secular stagnation story either, but in my mind the flattening of the yield curve is a red flag that the Fed has less room to maneuver than implied by the SEP. But maybe once the Fed actually starts hiking rates, market participants get the clue and the yield curve shifts up. I am not sure I am interested in taking that risk at this point, but no one is asking me to serve on the Federal Reserve Board.
One quibble with Krugman regarding his interpretation of the Phillips Curve:
Suppose the Fed waits too long. Well, inflation ticks up — probably not much, since the short-run Phillips curve looks very flat. And the Fed has the tools to rein the economy in. It would be annoying, unpleasant, and no doubt there would be Congressional hearings berating the Fed for debasing the dollar etc.. But not a really big problem.
Maybe two quibbles. First is that if you asked policymakers why the Phillips Curve was flat, I think they would say that nominal wages rigidities hold up the back end, while tighter policy holds down the front. In other words, the reason inflation does not accelerate at low unemployment rates is that the Fed tightens policy accordingly. Second, I think they equate "reigning the economy in" as triggering a recession. I think they find this more than unpleasant.
Bottom Line: If you want to know what the Fed is thinking at this point, a journalist needs to push Yellen on the secular stagnation issue at next week's press conference. Does she or the committee agree with Fischer? And does she see any inconsistency with the SEP implied equilibrium Federal Funds rates and the current level of long bonds?
