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Soon after I finished reading Larry Summers’ powerful argument against monetary policy tightening, Marcus Nunes sent me an equally powerful piece by Andrew Levin, who previously was a special adviser to Bernanke and Yellen (2010-12), and recently joined the faculty at Dartmouth. The intro paragraph lays out four arguments against tightening policy now.

The Federal Reserve is on the verge of triggering the process of monetary policy tightening. In particular, a number of Fed officials have indicated that the Federal Open Market Committee (FOMC) is likely to start raising its federal funds rate target within the next few months””and perhaps as soon as its upcoming meeting next week. Unfortunately, the rationale for that policy judgment rests on faulty analytical assumptions about the labor market, inflation dynamics, the stance of monetary policy, and the balance of risks to the economic outlook. Consequently, initiating monetary tightening at this juncture would be a serious policy error.

These four arguments are then developed in more detail. For instance, here are some comments on the balance of risks:

Over the past eighteen months, FOMC statements have regularly characterized the balance of risks to the economic outlook as “nearly balanced.” Of course, that assessment has recently come into question due to a bout of financial market volatility in conjunction with shifting prospects for major foreign economies (most notably China). Regardless of how financial markets may evolve in the near term, however, it seems clear that the balance of risks remains far from symmetric. If the U.S. economy were to encounter a severe adverse shock within the next few years (whether economic, financial, or geopolitical in nature), would the FOMC have sufficient capacity to mitigate the negative consequences for economic activity and stem a downward drift of inflation? For example, if safe-haven flows caused a steep drop in Treasury yields along with a sharp widening of risk spreads, would a new round of QE still be feasible or effective? Alternatively, would the Federal Reserve implement measures to push short-term nominal rates below zero, as some other central banks have done recently? In the absence of satisfactory answers to such questions, it is essential for the FOMC to maintain a highly accommodative stance of monetary policy as long as needed to ensure that labor market slack is fully eliminated and that inflation moves back upward to its 2 percent goal. Such a strategy will help strengthen the resilience of the U.S. economy in facing any adverse shocks that may lie ahead.

This may be the strongest argument against a rate increase now. I can understand both sides of the argument on the labor market—maybe wages will start rising more rapidly. But I really can’t see any good arguments on the other side of the balance of risks issue. The risks of waiting until 2016 are very low in terms of overheating and inflation. And I’ve never accepted the “financial” argument (bubbles, etc.) as having any validity at all. Everywhere it’s been tried (America 1929, Sweden 2010, etc.) it’s failed. Are there any successes? Does the Fed even have any Congressional mandate to go after bubbles? Is there a model they can point to that explains how monetary policy should prevent bubbles? Marcus also sent me a good paper on bubbles by Gadi Barlevy of the Chicago Fed. This is from the conclusion:

Finally, with regard to policy implications, my discussion highlights various difficulties in using greater-fool theories of bubbles to justify action against potential bubbles. Although these theories can provide some justifications for why policymakers should intervene, these rationales come with many caveats. For example, policymakers may have to know that traders have incorrect beliefs, even though policymakers would not necessarily be any better at forecasting future dividends than members of the private sector. Other justifications for intervention require policymakers to be perfectly attuned to when bubbles arise””a condition that seems implausible in practice. In fact, greater-fool theories of bubbles naturally suggest the opposite, that is, that detecting bubbles is likely to be difficult. Recall that in asymmetric information models, bubbles can arise only because there is the possibility of mutual gains from trade. Thus, there may be plausible reasons for why agents trade assets beyond trying to benefit at the expense of others. Finally, the social welfare implications that emerge most clearly in these models do not seem to capture the main issue policymakers are concerned with in regard to bubbles. For example, those who argue for a more forceful policy response to potential bubbles typically expect this response to come from central banks. This reflects a view that bubbles are fueled by loose credit conditions, as well as the idea that the collapse of a bubble causes the most harm when assets were purchased on leverage and a collapse in their price would trigger a subsequent round of defaults. Yet in most models of the greater-fool theory of bubbles, credit plays only a minor role or is missing altogether.

If the FOMC wants to go chasing after bubbles, that’s their decision. But don’t think there’s any scientific evidence supporting this quest. In contrast, there’s lots of scientific evidence that it would cost thousands of jobs, maybe hundreds of thousands.

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This entry was posted on September 09th, 2015 and is filed under Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



