Opinion | Lawrence Summers: What the Fed should do in inflation

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Lawrence H. Summers, a professor at and past president of Harvard University, was treasury secretary from 1999 to 2001 and an economic adviser to President Barack Obama from 2009 through 2010.

On Friday, Federal Reserve Chair Jerome H. Powell will give his third Jackson Hole address since inflation emerged as a major macroeconomic issue. These addresses are significant because they frame the monetary policy debate for the coming year. In his 2021 keynote, Powell supported markets by emphasizing why he thought inflation was transitory and well controlled — positions the Fed would abandon in the face of overwhelming evidence a few months later. Last year, he surprised and depressed markets by signaling the Fed’s dominant concern with inflation and its determination to keep tightening even at risk of slowing economic activity — judgments that have withstood the test of time.

Today, Fed rates are about 2 percent higher than markets or the Fed expected a year ago. Despite surprisingly high rates and a banking crisis in the spring, growth and employment have been strong, and inflation — while still well above the Fed’s 2 percent target — has come down substantially. There is intense interest in how Powell interprets these results, and even more desire for signals regarding future policy.

Here is what I hope to hear from Powell on Friday. More important, here are the perspectives that should inform Fed policy going forward.

First, I hope Powell emphasizes that what credibility the Fed enjoys is a consequence of its reversing course and taking resolute action to raise interest rates, and not an argument that it can afford to reduce its concern about inflation. At this time two years ago, the Fed dot plot (with the support of most commentators) was predicting zero rates into 2023. If the Fed had not repeatedly adjusted its policy path, inflation would be much more challenging today.

Second, I hope for a clear rejection of suggestions that inflation is securely under control. No serious observer ever believed that underlying inflation was as high as 6 percent, given the many specific and unusual factors leading to price hikes last year. And almost everyone agrees that it is still running well above the Fed’s 2 percent target, especially because current readings are likely depressed by deflation in some of the sectors where prices spiked last year.

It is highly welcome — and not what I predicted — that underlying inflation has come down by about 1 percentage point, even with very low unemployment. But this good news far from assures victory over inflation. A continuation of recent trends cannot be taken for granted. Wage inflation on the monthly Bureau of Labor Statistics measure was higher last month than last quarter, and last quarter was higher than last year. Union wage settlements in highly visible areas such as parcel delivery and airline piloting might establish generous norms.

Further grounds for concern come from major labor cost pressures in the health sector, upward adjustment in consumer price index health insurance measures, rising gas prices, and climate and geopolitical influences on commodity prices, along with growing indications that residential rentals will start to rise in cost. It is sobering to recall that the shape of the past decade’s inflation curve almost perfectly shadows its path from 1966 to 1976 before it accelerated in the late 1970s.

Third, I hope Powell will recognize that the dramatic change in the U.S. fiscal position has major implications for monetary policy. Most obviously, major increases in demand coming from federal deficits (along with mandated and subsidized investments in green technology and climate resilience) likely mean that R-star — the so-called neutral interest rate — has risen substantially and, given a deteriorating fiscal trajectory, probably will rise further. These sources of increased demand are very likely major explanations for why the economy has remained so robust despite radical increases in interest rates. This means interest rates have to be considerably higher than they were previously to achieve any given level of restraint. I do not regard as plausible the Fed’s stated view that the long-run neutral interest rate is 2.5 percent.

There is an additional aspect that has received less attention. The Fed’s use of QE — quantitative easing — policies, whereby it creates floating-rate bank reserves and buys long-term bonds, had the effect of shortening the maturity of the debt offered by the government to the market at just the moment when long rates were very low. For the foreseeable future, the Fed will be losing tens of billions of dollars a year (ultimately at taxpayer expense) as the rate it pays banks far exceeds what it earns on past purchases of long-term bonds. Now, the Fed is reducing its risk and lengthening the maturity of outstanding federal debt by selling off long-term bonds. Unless it interferes with financial market functioning, this policy should be maintained. Given our problematic debt trajectory, the United States should be terming out its debt.

Fourth, the chairman needs to respond explicitly or implicitly to the growing chorus suggesting that the Fed should adjust its inflation target. For years, the Fed has been firm in its commitment to 2 percent. Of course, there are legitimate academic arguments about the merits of having a numerical target and, if so, what it should be. But timing and context are crucial. The Fed’s preferred price index has risen 7 percent faster than its target since January 2021. Debt and deficits are at record levels, and a presidential election is fast approaching. A central bank’s most important asset is its credibility. Loss of that risks higher inflation, interest rates and ultimately unemployment, as in the 1970s. Maintaining credibility requires the Fed making clear — and without hints of dissent from the administration — that the commitment to achieving 2 percent inflation is absolute both now and for the foreseeable future.

Fifth, I hope the chairman will remain agnostic about the future path of policy, even as he emphasizes the importance of containing inflation. Neither the Fed nor anyone else can be confident in their ability to forecast the economy. I am aware of no evidence that ever-more-frequent and specific central bank communication reduces volatility, and the gyrations that frequently coincide with post-Fed Open Market Committee news conferences suggest otherwise.

What we know now is that inflation is still too high, labor markets are tighter than they have been since World War II, fiscal deficits are at near-record peacetime levels and stock prices are high. This suggests a need to recognize that it might well prove necessary to hit the brakes some more — and that it might well be a long time before it is prudent to cut rates.

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