Last Wednesday the Federal Reserve wrapped up its two-day March FOMC meeting and announced a largely expected 25 bp rate hike, the first such action since December 2018. Back then the markets threw a tantrum, dropping 9% on the month, causing the Fed to back off any further actions, because, you know, the 'Fed put.' Beginning with Ayn Rand-devotee Alan Greenspan, Fed Chairpersons have, to a great extent, measured their job performance against the fortunes of the stock market, the most visible, though inaccurate, reflection of the broader economy. But for much of the post-GFC period inflation and economic growth had stayed stubbornly low, and after a while the Fed's highly accommodative policies primarily served to boost financial markets. The only real issue was asset inflation and historic inequality--but, almost by definition, that doesn't matter. Trickle down, right?
Well, things are a little different now, with inflation at a 40-year high, and potentially getting worse. The Fed is in the uncomfortable position of choosing between its favored measured of success, the stock market, and its actual mandate of price stability. But old habits die hard, and the Fed moved gingerly last week with a 0.25% hike and a lot of soothing talk. The markets ripped higher, almost as if laughing at the prospect of the Fed being more aggressive, led curiously by retail investors (?). But being aggressive--a lot more aggressive--may be what's needed, according to Harvard economist Larry Summers. Prior to the FOMC meeting last week, Summers wrote that the Fed needed to hike rates to at least 5% or risk bringing stagflation and recession on the US economy. Following the FOMC's relatively tepid rate move, Summers responded with a stinging Op-Ed in the Washington Post, saying: "The stock market responded positively Wednesday to the Federal Reserve’s move to raise interest rates...I wish I could share that enthusiasm. Instead, I fear, the economic projections of the Federal Open Market Committee (FOMC) represent a continuation of its wishful and delusional thinking of the recent past." Wishful and delusional; tell us what you really think Larry.
Summers' argument stems from what has been a central principle of anti-inflationary monetary policy for decades, namely that to reduce inflation it is necessary to raise real rates. He writes "yet, because of upward revisions in the inflation forecast, the Fed’s predicted real rates have actually declined in recent months. In other words, the FOMC’s plans do not even call for keeping up with the rising inflationary gap. It is hard to see how interest rates that even three years from now will be about 2 percentage points less than current rates of inflation can reasonably be regarded as providing sufficient restraint." He goes on to say "perhaps the FOMC members are wary of pessimistic forecasting. But why shouldn’t they forecast realistically...the credibility of the Federal Reserve is a precious asset. It should not be lightly sacrificed."
And yet, ironically, Summers may be part of the reason the Fed has been so cautious to begin with. Summers has been successful at reviving the idea of 'secular stagflation' in recent years, which is that demographics, global savings glut, and technology trends are reducing growth and inflation, and the imbalance between savings and investment is pulling down real interest rates. Buttressing the case is what we had seen over the past two dozen years in the U.S. and Europe and perhaps far longer in Japan, at least until the pandemic. Growth has been consistently below expectation, with chronically sluggish demand and low inflation, "just as one would expect in the presence of excess saving. Absent many good new investment opportunities, savings have tended to flow into existing assets, causing asset price inflation." The Fed seemed to buy into that thinking when they persistently described inflation as "transitory." Even after Summers had reversed course in 2021 and warned that continued large scale monetary and fiscal stimulus in response to the pandemic could lead to price instability, many still felt secular stagflation was the bigger risk. In fact, Paul Krugman, quoted Summers to Summers to make the convincing case more stimulus was warranted.
Whether it was the market's response, Summers' comments, or whatever, by Monday the Fed took a much harder tone on rates, with Chair Powell stating, "the labor market is very strong, and inflation is much too high," and that the Fed was open to multiple 50 bps rate hikes and, perhaps, even reducing the Fed balance sheet at the same time. Okay...
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