Scott Sumner has a new post on Econlog discussing challenging the meaning of 25 basis points increase in the FF rate. It is packed with content of high educational value for understanding how adjusting short term nominal interest rates works. I’ve made a note of it for my recommended reading list, as one simply cannot understand news articles and parlor discussions about monetary policy without understanding these points.
But being a layperson I tend to look at topics from a higher, 20,000 ft. level. At that level I see that Summers and Krugman agree with Sumner on the general idea that raising the FF rate 25 basis points now is a bad idea. And this is a good thing. Why they agree or whether they are in violent agreement isn’t really that important – except I am now even more educated about why the Fed’s IOR implementation in 2008 was a huge mistake. But that doesn’t change my disposition toward Summers and Krugman.
In my opinion, the most important part of the post was in the first few sentences (emphasis is mine):
Paul Krugman and Larry Summers have recently argued that the Fed should not raise rates later this year. I agree, mostly because I believe it will prevent them from hitting their announced inflation target, but also because it slightly increases the risk of another recession. If anything Summers and Krugman seem even more concerned about recession risk than I am.
The portion of the quote in bold is an interesting short cut across what, if I had been writing this post, would have been my main theme. The risk of recession isn’t really about short-term nominal interest rates because if they are off the mark a bit this way or that, it makes little difference. I’ve read discussions over the last year about the natural interest rate having risen. Some have even surmised that it is positive. If that’s true, then the risk is indeed minimal – in principle. Our central bankers keep telling us the economy can handle it. I believe them.
But what is being discussed here, if I may be so bold, is that the risk of recession is really about not hitting the target, having no credibility in maintaining the target, unintentionally broadcasting that the target is meaningless, and then sending the pebble rolling down the hill with nobody in particular understanding the Fed’s reaction function, the thereafter. It’s a credibility problem that can have a dramatic impact on the demand for money and the passive stance of monetary policy while facing volatility that gets out of control. The rate hike tempts fate against known weaknesses and communications problems of the current monetary regime. The latest minutes released by the Fed says so much, only in different words. The Fed lacks traditional tools to deal with problems.
Stated in that way, I hardly see the importance of the difference between Summers, Krugman and Sumner when thinking about the greater impact to the public at large.
It would be nice if life were so easy that central bankers could make crises go away by just wishing them away or acting like they are over before they really are. We aren’t back to 100% economic health, and whether or not we can withstand a rate hike while skirting recession is entirely beside the point of what monetary policy is supposed to achieve. The Full Employment and Balanced Act says exactly what monetary policy is supposed to achieve, and we are not there. The tools to hike interest rates are not there to just hike ‘em as long a recession can be avoided. Central Bankers do not exist to just hike interest rates.
For a rate hike to be justified it must be linked to a goal, otherwise it is being done just to be done. The Federal Reserve has linked it’s mandates from the Full Employment and Balanced Growth Act to a 2% inflation target, meaning that monetary policy serves its intended purpose when it maintains a 2% long term inflation goal. Whether 2% is the right goal can certainly be argued. But in the current context, that is simply an academic exercise because the Fed is a long way away from meeting even the goal it chose itself.
And so, one might just wonder… why are we even having this conversation? It wouldn’t be far off the mark for one to conclude that the Fed is entirely disjointed from nearly every aspect of governance and probably reality, and is not currently serving a meaningful purpose to society if it cannot articulate understandable rationale for its choices.
The most important question to be answered right now, is not can we take this. But rather the question of the day is: Why we should have to? Because, surely, we will all feel the impact of tempting fate – and the reason for it is so much more important than the size.