Is Larry Summers right that the rate hike is premature?
Larry Summers has been very consistent with his view that “monetary policy should not be tightened until we’ve seen the whites of the eyes of inflation.” (Q&A: Lawrence Summers and Why It’s Too Early to Raise Rates). His views may be deemed right or wrong depending on one’s own perspective, and I will share some of these views at the end.
Larry Summers’ views:
Much of the economic weakness we’ve seen now are cyclical in nature
Low inflation reflects the following economic conditions
Soft patch in the U.S. economic conditions
Global growth weakness with uncertainties in China, Japan and Europe
Energy price decline weigh on headline inflation, and “pass-through” effects impact core inflation
Dollar strength pushes down foreign import prices to weigh on core goods inflation
There are little signs of financial instability, or the cost of ultra-accommodative monetary policy
It is easier to hike rates to fight faster than expected rise in inflation than to offset surprise economic weakness with rates near zero lower bound
Financial conditions have already tightened, and Federal Reserve’s work had been done by financial markets
Some of the views which I share:
The U.S. labor market has been undergoing structural changes, and soft-patches in the job market (the “hollowing out” of middle skill jobs) is part of a longer macro trend. Lower rates cannot induce companies to change their hiring preferences. The below charts are from Dallas Fed’s May 2014 Economic Letter “Middle-Skill Jobs Lost in U.S. Labor Market Polarization.” It may take significant amount of time for a middle-skill worker to “re-tool.”
Below is a comparison of net employment gain and loss between Jan 2009 and Nov 2015 (Sources: Bloomberg, L.P. and my own calculation, number in thousands):
The inflation picture is more nuanced – much of the decline in headline inflation since 3Q 2014 has been due to energy (headline inflation) and dollar (core goods inflation), but core services inflation (rent, etc) had been trending strong. Researchers at the Federal Reserve Bank of New York argued that Core Services tend to be more correlated with labor market conditions, and Core Goods related to dollar valuation and foreign conditions. I would like Cleveland Fed’s analysis: The Gap Between Services Inflation and Goods Inflation.
It is true that financial conditions have tightened (Mr. Summers quoted both GS and Chicago Fed’s measure of financial conditions here: Why the Fed must stand still on rates), but FCI indices have been strongly influenced by dollar valuation. FCI indices include the following:
Once dollar’s effect is removed, measures of financial conditions would return to a level to indicate that FCI is infact quite loose.
The below chart is from the FT blog post: financial conditions and a catch 22 for the fed. If one agrees that much of the recent tightening of FCI had been due to dollar, then one would also come to see that stock valuation is still relatively high, and yields still relatively low (thus borrowing cost is still relatively low)
In summary, I see the following:
Ultra accommodative policies will not further boost a labor market that is showing signs of structural mismatch
Inflation is more nuanced and weighed down by transient factors. Waiting until inflation is close to or at mandate level would be too late, given monetary policy’s long and variable lag in affecting the real economy
Financial distortion and stability risk from years of ultra accommodative policy is notable, if not already significant
Financial condition indices are skewed by dollar strength, masking relatively high equity valuation and low medium and long-term yields
From the above perspective, I would prefer to argue for a different policy stance (much closer to the FED) than Larry Summers’ position.