A Benjamin Cole post
There is something deeply askew about U.S. Federal Reserve policy statements and policies, and, indeed nearly the entire U.S. economics profession.
For example, a Richard Fisher (former Dallas Fed President and FOMC member), an Alan Meltzer or even a Martin Feldstein can go into sweat-drenched hysterics and predict hyperinflation holocausts, and be consistently wrong for years and years, yet still be VSPs.
But no one predicts lethal (to economic growth) deflationary recessionary vortices. I do. I guess if I am wrong for the next 10 years running—well, then I will still be a VUP (Very Unserious Person).
The Threat Is?
But yet, what is the threat today? Inflation or Prolonged Deflationary Recession?
Has Japan ever escaped its low-growth deflation? Can anyone speak confidently of Europe escaping its deflationary recession?
No recovery lasts forever. At current inflation and interest rates, a recession in the U.S. would surely result in deflation and zero lower bound all over again.
But the Fed has set aside QE, and shows no inclination of lowering interest on excess reserves. To go back to QE or eliminating IOER would mark a humiliating flip-flop on policies—and all the while the naysayers would be screaming, “QE didn’t work. See? We are in a recession again. Only tight money works.”
So the Fed will enter the next recession hamstrung, slow to respond to declining prices and recession (I mean ever slower than usual).
The above scenario perfectly sets up a lethal deflationary recessionary vortex, sucking down equities and property values, eviscerating U.S. savings and balance sheets, scaring off investment in plant and equipment. The Fed will be flat-footed while the economy tanks, and unemployment soars. Federal deficit spending will balloon again, resulting in calls for austerity.
Dudes, it will get ugly.
Instead of welcoming a deflationary recession, the Fed should immediately consider “normalization” of interest rates—on excess reserves, which normally earned no interest.
And if the Fed ever wants real interest rates to be “normalized”, i.e., higher than zero, then it has set help set up sustained and robust economic growth. A central bank cannot “normalize” interest rates through monetary suffocation.
In other words, print more money. Like I always say.
“At current inflation and interest rates, a recession in the U.S. would surely result in deflation and zero lower bound all over again.”
I suppose you should add, to keep Scott happy and to not confuse newer readers: “assuming the Fed sticks to its 2% or less (preferably less) inflation target and subordinates the other half of their dual mandate to support maximum employment”.
A bit less punchy though.
Slightly off topic – Low Unemployment and Maximum Employment are quite different things. Thinking here of the participation rate, of course.
James–Right you are on all counts. Indeed, Germany has boosted its LPR in the last 12 years, I think by about 10% or so. The US should seek to do something along the same lines.
Speaking of Scott Sumner, I think he is terrific, but perhaps still insufficiently cynical or skeptical about Fed performance. If the Fed adopts a 3% NGDPLT, we will mire in a recession and never get out, as all central bankers are obsessed with inflation and not real growth.
Egads, if we had real GDP fall by 1% and 4% inflation (resulting in NGDPLT of 3%), the Fed would tighten to fight inflation, forget the target.
The economy needs a big cushion against central bank proclivities to cause perma-recessions. Shoot for 6% to 7% NGDPLT.