Five reasons to doubt Yellen and the Fed’s wisdom

by: Lawrence Summers


While I do not believe the Federal Reserve made a serious mistake on Wednesday in raising rates, I believe that the “preemption of inflation based on the Phillips curve” paradigm within which it is operating is highly problematic. Much better would be a “shoot only when you see the whites of the eyes of inflation” paradigm of the kind I have advocated for the last several years.

Such a paradigm would be more credible, more likely to result in the Fed’s satisfying its dual mandate, reduce the risk 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 suspect, for reasons I will write about in the next few days, that moving away from inflation targeting to something like nominal gross domestic product level targeting would be a better idea. But I believe this issue is logically subsequent to the question of how policy should be made in the near term with the given 2 per cent inflation target.
Five points frame my doubts about the current approach.
First, The Fed is not credible with the markets at this point. Its dots plots predict four rate increases over the next 18 months compared with the markets’ expectation of less than two. Table 1 shows the Fed has been highly unrealistic in its forecasts for several years now.

There are some caveats in comparing market and Fed forecasts. Fed chair Janet Yellen is not necessarily the median dot but has disproportionate influence. Additionally, the dots refer to the modal (most likely) rather than the average future scenario. Both those factors might tend to make the Fed forecast overstated, if Ms Yellen is more dovish than the Fed as a whole. But, on the other hand, market forecasts contain term premiums that are on average positive, implying that market expectations for Fed policy should also be biased to the upside. In sum, there is no rationalising away the protracted pattern of Fed forecasting errors except to doubt the models on which the Fed is relying.

The truth is that 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. Table 2 shows than neither inflation indexed bonds nor the swap market expect the Fed to hit its 2 per cent personal consumption expenditure (PCE) inflation goal in the foreseeable future.
If the Fed were equally behind the curve with respect to rising inflation there would be hysteria among the commentariat. They would be proclaiming that the Fed has to move decisively so as not to be behind the curve. Why should there not be concern about disbelieved forecasts of actions that if taken would push inflation further below target than current forecasts?

Second, the Fed regularly proclaims that it has a symmetric commitment to its 2 per cent inflation target. Recoveries do not last forever and when recession comes inflation declines. So why would the Fed want to be projecting only 2 per cent inflation entering the 11th year of recovery with a jobless rate clearly below their estimate of the non-accelerating inflation rate of unemployment (Nairu). Such a prediction is coming after a full decade of sub-target inflation. As shown in the graph below, the PCE core price level is a full 4.3 per cent below where it would be had it risen by the Fed’s target amount over the past decade.

Accordingly, policy should be set with a view to achieving modestly above-target inflation, perhaps 2.3 or even 2.5 per cent, during a boom with the expectation that it will decline during the next recession. A higher inflation target would entail easier policy than is now envisioned.

Third, pre-emptive attacks on inflation, like pre-emptive attacks on countries, depend on the ability to judge threats accurately. The truth is 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 last 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.

At some points these might seem like theoretical arguments. But in recent months both overall and core inflation have come down along with market and survey measures of inflation expectations. The most widely followed inflation measure, the consumer price index, has decelerated from 2.5 per cent inflation in January to 1.9 per cent now. Accordingly, inflation expectations have fallen 0.2-0.3 per cent. This behaviour is contrary to all the Fed staff models.

With inflation and inflation expectations below target and declining there would be little case for pre-emption even if inflation above target was a serious problem. But, as we have seen, there are strong reasons for thinking that the Fed should to be consistent with its mandate and let inflation rise above 2 per cent.

Fourth, as I have stressed in my writings on secular stagnation and in arecent conversation with David Wessel, 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 per cent funds rate is especially expansionary in the current environment. And I am confident that if the Fed errs and tips the economy into recession the consequences will be very serious given that the zero lower bound on interest rates or perhaps a slightly negative rate will not allow the normal countercyclical response. This, too, counsels a bias towards expansión.

Fifth, a “whites of their eyes” paradigm does not require the Fed to abandon its connection to price stability. It simply needs to assert that its objective is to assure that inflation averages 2 per cent over long periods. Then, it needs to acknowledge that while inflation is persistent, it is very difficult to forecast and signal that it will focus on inflation and inflation expectations data rather than measures of output and employment in forecasting inflation.

With these principles internalised, 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.

How to Keep the Fed From Following Its Models off a Cliff

For one thing, governors should have varied life experiences to broaden the perspectives in the room.

By Glenn Hubbard

The Federal Reserve building in Washington, D.C. Photo: Getty Images

Wednesday’s decision by the Federal Reserve to raise the target for the federal-funds rate by 25 basis points has continued a debate about the tightening cycle. Yet these “Fed watching” discussions aren’t necessarily productive. It would be better to rethink the Fed by evaluating its strategy, structure and accountability.

How can the institution be restructured to better achieve its goals of financial and price stability? The late economist Allan Meltzer, a scholar and historian of the Fed, gave the central bank high marks in these objectives in only about a quarter of its years in operation. An understanding of why the Fed succeeded and failed in the past is a natural guide to reform.

Economists emphasize two factors accounting for periods of Fed failure: political influence on Fed decisions and adherence to false models of the financial system and the economy. In the first, the Fed’s balance sheet or regulatory power may be hijacked in service of the government’s near-term electoral or fiscal objectives. In the second, ignorance of economic conditions or doctrinaire attention to false models may blow Fed policy off course.

Independence, sometimes put forth as the key insulation against politicization of the Fed, has not proved sufficient to guarantee stability. Policy errors during the Great Depression, the inflationary period of 1965-79, and the accommodative run-up to the 2007-09 financial crisis all occurred during times of substantial independence. Nor is ostensible freedom an antidote to politicization, as political pressures certainly figured in the 1960s and ’70s.

Milton Friedman recognized the limits of independence—given the choice of an independent central bank with complete discretion, a commodity standard, and a monetary rule, he chose the rule. For today’s debate, I would say an institution capable of executing a framework for price and financial stability needs independence from formal government control. But such a framework must be clear and credible at all times: specifying an analytical approach, laying out how departures from normal financial and economic conditions will be addressed, and explaining those departures when they occur. Call it “maintain and explain.”

Structural reforms of the Fed can mitigate political influence. First, a credible, simple monetary framework can offer significant insulation from political pressure, while increasing the likelihood of success in achieving the Fed’s objectives. Inflation targeting—that is, a commitment to conduct monetary policy consistent with a target long-run inflation rate—is a familiar example for a goal. Likewise, the Fed should describe the balance-sheet size it believes it requires for the conduct of monetary policy. And it should spell out mechanisms it will use in lending during times of stress or crisis.

The Fed should also specify an operating framework. This could include, for example, following a variant of the Taylor rule, which sets an ideal level for the federal-funds rate based on output and inflation. Another crucial step: a mechanical path for normalization of the balance sheet and clarity about the assets the Fed will hold. Limiting itself to only Treasury securities, for example, would prevent opportunities for political pressure to be brought on the Fed not to acquire or sell them.

Allowing Fed officials discretion to deviate in times of stress would enhance their credibility—but only if such decisions are explained clearly in advance and are consistent with the overall framework. This maintain-and-explain process would enhance understanding of the Fed’s success in achieving its objectives and enforce accountability when it is not. Such discretion also would grant flexibility in monetary policy and lender-of-last-resort actions in periods of stress.

While a clear and consistent framework gives the Fed a strategy, structure remains important.

Giving the Fed a larger role in financial regulation has proved to be fraught with opportunities for political pressure, since elected officials can review such regulatory actions. This was the case after the financial crisis, when the Fed’s regulatory power expanded and its political scrutiny did too.

Strategy and structure matter, but ultimately personnel is policy. Including regional bank presidents in the Federal Open Market Committee brings intellectual and political diversity to the Fed decision-making process. Choosing Fed leaders committed to the maintain-and-explain framework and to resisting political influence is essential as a last line of defense.

The false-model account of Fed failure played a role in the Great Depression, the inflationary ’60s and ’70s, and the pre-financial-crisis years. During the Depression a failure to discriminate between real and nominal interest rates, as well as the now-discredited “real bills doctrine,” were enabling failures. The Fed’s emphasis on the simple Phillips curve also built in a policy bias toward accelerating inflation several decades later. And the Fed from 2002-05 placed too little weight on financial imbalances encouraged by an easy-money policy.

Three steps can bolster defenses against false models. The first is to strengthen research inside and outside the Fed on the integration of finance and monetary policy and the economy, an intellectual gap exposed by the financial crisis. Second, Fed officials should interact more with market participants and businesspeople to understand financial innovations and economic developments better. Policy should be more reflective of proactive data gathering than reactive data dependence. Finally, Fed governors should be chosen with varied life experiences to broaden economic perspectives and encourage a healthy skepticism about prevailing models.

The Fed faces a challenge in crafting and explaining normalization of the extraordinary measures undertaken during the financial crisis. There is now also an opportunity to make personnel decisions that shape the Fed’s strategy, structure, and accountability. Fortunately, experience with Fed success and failure offers a road map.

Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush.

Manipulated and Made-up Markets

By: Michael Pento

The economic ruse that is run by Communist China is growing bigger by the day. The formula behind what has been the Great Red Engine of global growth is really very simple: Print new money and funnel it through the state-owned banking system in order to entice businesses and individuals to incur a debilitating amount of non-productive debt.

Historically speaking, countries that have utilized this ersatz form of economics have suffered a currency and bond market crisis. But the command and control government of China always seems to be one step ahead of the laws of economics; and has been able to defer the inevitable day of reckoning due to its large currency reserves.

However, those reserves have dwindled as the nation was forced into selling its dollar-based assets and defend the value of the yuan. The People's Bank of China (PBOC) has spent trillions of dollars over the past four years doing just that.

To aid in propping up the yuan, China has deployed a unique cocktail of regulations and market trickery. In addition to outright currency manipulation, trading bands and strict capital controls, China has now resorted to simply making up prices for its currency.

The China Foreign Exchange Trade System, which is managed by the PBOC, changed the way it values the country's currency each morning and the way it is allowed to fluctuate through the day. The government currently sets a benchmark value for the yuan against a basket of currencies for which the yuan is then allowed to fluctuate in value by 2 percent during the day.

You would assume the opening benchmark level would be based on the currency's closing value the day before.

But the Chinese government contends that the market just isn't getting it right. Therefore, they are introducing a "countercyclical variable". The omniscient Chinese government will now determine the opening benchmark value of the currency. Because after all, the government of China is great at pretending it has a better view of supply and demand than millions of individuals voting with their wallets each day.

But the currency manipulation doesn't end there. The Chinese government still has the less regulated offshore yuan to contend with. Investors that believe the yuan will fall in value will go short the currency outside of China. This involves borrowing yuan in Hong Kong, swapping it for dollars and then repatriating it back at a more favorable rate. There are risks associated with borrowing the yuan.

When these risks rise it can force investors to close out this trade, which has the effect of pushing the yuan higher.

Therefore, in order to crush the Yuan bears, China followed up its countercyclical variable by sending margin costs for borrowing the offshore yuan through the roof and forcing a short squeeze.

The overnight CNH Hibor rate, spiked from 5.35% on May 30th, to 42.8% by June 1st, making the cost of borrowing new yuan funds prohibitive; and thus forcing many speculators out of their positions. And with this it appears China's currency will live to die another day.

We are living in a world where market manipulation has reached unprecedented proportions and any vestiges of the free market are extremely hard to find. This is especially true throughout the developed world. China sets a GDP target and then fudges with the number to ensure its accuracy. It fabricates economic numbers and is the world leader in the production of alternate facts. Spinning a fairy tale as it pretends to move towards a more market-based system.

But to imagine China can repel these economic forces forever would be to defy centuries of data that says otherwise. The offshore Yuan speculators represent the incipient dissolution of confidence in the government and its currency. The Chinese government can only manipulate the message from the market for so long.

For example, the US dollar had supreme confidence following WWII and the Bretton Woods agreement. But by the early 1970's money printing caused the government to abandon the dollar's gold backing, and stagflation soon followed. Heck, even the Roman Empire couldn't hold back the forces of inflation forever.

This destruction of confidence in governments and their fiat currencies do not happen overnight. But history is clear that markets always win and governments always lose...reality triumphs over fiction.

China's fairy tale will come to an end. A pernicious end that will be shared by the Euro and the Dollar as well. Those seeking a much better ending will need to park their wealth in gold.

Britain’s Norway Solution

Anatole Kaletsky

Theresa May

LONDON – Shortly after UK Prime Minister Theresa May’s decision to call an unexpected “Brexit election,” I wrote that pro-Europeans in Britain might yet snatch victory from the jaws of defeat. But the timescale I had in mind was five years, not five weeks.
How long May will survive as prime minister is impossible to predict. Her fate will depend on personal vendettas and Byzantine political rivalries, not only in London, but also in Edinburgh and Belfast. But in trying to anticipate the outcome of the Brexit negotiations, the questions that matter no longer have much to do with May’s political survival.
Are Britain’s parliamentary arithmetic and public opinion moving in favor of or against the “hard Brexit” – a drastic clampdown on immigration and withdrawal from the European Union’s customs union, single market, and legal jurisdiction – planned by May before the election? And if Britons are turning against May’s agenda, will EU leaders offer them a face-saving compromise similar to that offered to Norway, which remains outside the EU’s institutional structures, but accepts most of the obligations and costs of EU membership in exchange for the commercial benefits of the single market?
An EU relationship similar to Norway’s is the only model that could attract public and political support in Britain, without threatening EU principles or inflicting serious economic costs on either side. The institutional arrangements for this option already exist, in the form of the European Economic Area (EEA), a sort of anteroom to full EU membership, currently occupied by three small but prosperous European countries: Norway, Iceland, and Liechtenstein.
These countries considered EU membership in the late 1980s, but for various reasons decided not to join. All wanted to integrate their economies and labor markets with Europe, and, after the Brexit vote, Britain was widely expected to try to negotiate a Norwegian-style EEA arrangement, rather than the rupture proposed by May.
It was only last September, three months after becoming prime minister, that May surprised the world by effectively ruling out the EEA option, telling the Conservative Party’s annual conference that those who call themselves “citizens of the world” are really “citizens of nowhere,” and that the free movement of people required by EEA membership was therefore unacceptable. In January, she officially announced that Britain would not seek membership of the EU single market, because this would require free movement, a position confirmed in the Tories’ election manifesto.
But is May’s aversion to immigrants still relevant, now that the election on June 8 has made her a lame duck and unstable parliamentary alignments and the shifting balance of public opinion will drive the Brexit negotiations?
Public opinion on immigration will be the most important determinant of Britain’s European policy in the months ahead. And the unexpected election outcome, backed by strong evidence from polling, suggests that public attitudes concerning the free movement of people are more nuanced and less hostile than May’s rhetoric and the Conservative manifesto had assumed.
In fact, British voters mostly support free movement, if it is presented not as an anti-democratic imposition by foreign bureaucrats, but rather as a right that British and EU citizens reciprocally enjoy. In May, YouGov, the British polling company that came closest to predicting the election result, added to their final pre-election poll of 1,875 voters the following question: “In negotiating Britain’s departure from the European Union, do you think our government should offer EU citizens the right to travel, work, study, or retire in Britain, in exchange for EU countries giving British citizens the same rights?” (Full disclosure, this question was suggested by Best for Britain, an organization I helped to establish and chair.)
The answers defied conventional wisdom. Voters in this carefully weighted sample favored free movement by four to one. Sixty-two percent said “yes,” 17% “no,” and 21% answered, “don’t know.” Moreover, there were clear majorities in favor of free movement in every sub-group of the sample, whether categorized by age, region, or political-party support, with one exception: the small minority of voters who supported the anti-immigrant UK Independence Party.
The upshot is that a new relationship based on the EEA model, allowing Britain to keep most of the benefits of the EU customs union and single market alongside free movement of people, would not only be economically less painful than a hard Brexit; it would also be supported by a large majority of voters. The combination of single-market membership and free movement would be particularly popular with the large cohort of young people who turned out to vote last week for the first time and who consider the ability to live, work, or study anywhere in Europe a major benefit of EU membership, not a cost.
From the standpoint of British politics, it is possible that EEA membership will become the lodestar steering Brexit negotiations in the months ahead. But how would the EU respond?
For other EU countries, a Brexit negotiation based on EEA membership should be a perfectly acceptable, even welcome, outcome. EEA membership would not amount to British “cherry picking” of EU benefits, which other countries have understandably refused to accept.
This is because, by almost any standard, EEA membership is clearly inferior to full EU membership. In addition to accepting free movement of people, EEA members must follow EU commercial rules and accept decisions by the European Court of Justice, without any formal role in making these rules and decisions.
For these reasons, when the EEA was established in 1994, it was intended only as a temporary transitional arrangement for countries – such as Austria, Sweden, Finland, and Norway – which planned to become EU members, but were not ready to join. For Austria, Sweden, and Finland, full membership came as intended. But in Norway, voters rejected EU membership in a referendum and still do. Norway’s “temporary” EEA membership has now stretched to 23 years. Could this be a precedent for Britain?