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12 17 2015 | by Victor Xing | Economics

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:

  1. Much of the economic weakness we’ve seen now are cyclical in nature
  2. Low inflation reflects the following economic conditions
    1. Soft patch in the U.S. economic conditions
    2. Global growth weakness with uncertainties in China, Japan and Europe
    3. Energy price decline weigh on headline inflation, and “pass-through” effects impact core inflation
    4. Dollar strength pushes down foreign import prices to weigh on core goods inflation
  3. There are little signs of financial instability, or the cost of ultra-accommodative monetary policy
  4. 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
  5. 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.”
Larry Summers sees job losses as cyclical in nature
Larry Summers sees job losses as cyclical in nature
Larry Summers sees job losses as cyclical in nature
Many companies had taken the opportunity to increase automation and reduce routine labor during the recession, and those positions were never filled when the economy improved.
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):
Larry Summers still see cyclical weakness in the labor market
Job gains have been lower wage jobs (the Professional, Scientific, and Technical Services also include lower wage temporary staffing jobs)
Larry Summers still sees cyclical weakness in the labor market
Job losses have been middle wage jobs – lower rates has questionable efficacy on bringing back manufacturing jobs


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.
Larry Summers prefers to wait until headline inflation is near mandate levels
Larry Summers prefers to wait until headline inflation is near mandate levels
Larry Summers prefers to wait until headline inflation is near mandate levels
Latest CPI report shows decent growth in rental and core inflation, and the components sensitive to foreign import prices (dollar valuation) and energy are still struggling

Financial stability

Lower for longer had induced investors to “reach for yield” – the U.S. shale revolution was funded thanks to massive issuance of high yield bonds, and the subsequent overproduction resulted in the price war between shale producers and Saudi Arabia (as well as its decision to keep production high in order to weaken shale producers by forcing prices down).  The end-result is the energy crash which we are now seeing today.  Please also refer to: Is the mining and resources boom about to move into the next phase of growth, or are we headed for a world recession for many years?
Larry Summers prefers to see headline inflation rises further
Sources: Bloomberg, L.P., my own calculations
In my opinion, the rise and fall of the U.S. shale boom is a very good example of financial stability risk.  I am also concerned about the growth of bond funds during the past decade of bond bull market, and a sudden rush to exit may have severe impacts on our economy:What do global financial leaders think will be the outcome of the next major systemic disruption, say of the magnitude of the 2009 near-collapse of the US financial system?

Financial conditions

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:
  • Dollar valuation
  • Bond yields
  • Stock valuation
  • Credit spreads
  • Energy prices
Larry Summers sees financial conditions as "already tightened"
GS Financial Conditions Index appears optically tight (Sources: Goldman Sachs, Bloomberg, L.P.)
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)
Larry Summers referred to the aggregate financial conditions (including dollar)


In summary, I see the following:
  1. Ultra accommodative policies will not further boost a labor market that is showing signs of structural mismatch
  2. 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
  3. Financial distortion and stability risk from years of ultra accommodative policy is notable, if not already significant
  4. 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.
I would also like to emphasize that I prefer not to judge who is right or who is wrong – recall former FED Chair Bernanke and Larry Summers’ public “fight” over their views on secular stagnation: Larry Summers and Ben Bernanke are having the most important blog fight ever
I think it is just different perspectives.
Original Quora article

Next article12 16 2015 | by Victor Xing | Central Banks

December FOMC: “End of an extraordinary 7-year period”