This post is almost identical to one that appeared on
There are times when I am quite pleased that Marty Feldstein, whom I admire as a professional economist and consider a friend, is not Chairman of the Federal Reserve Board. This is because his policy recommendations at the end of his Jackson Hole presentation amount to the proposal that the Fed forget about price stability and instead focus solely on cutting interest rates to minimize the likelihood and depth of a serious slowdown/recession in the US. That advice is dangerous. It is also rather surprising for Marty to express so much concern about a significant fall in
Marty’s analysis of the origins and likely future course of the current financial turmoil in the
Extremely low credit risk spreads (as well as low long-term real interest rates) were a feature of the global economy, not just of the
Home building in the
But is a significant decline in
Given the prevailing nominal rigidities in
The only mechanism to mitigate this, other than a fiscal expansion which would further weaken the external balance and also not do much for the national saving rate, would be a significant reduction in the US external trade deficit, brought about through an already weak and further weakening US dollar. This scenario would indeed become more likely were the Fed to cut its policy rates.
Marty, however, wants to use lower interest rates to stimulate every component of aggregate demand, with the possible exception of public spending on goods and services: “…lower interest rates now would help by stimulating the demand for housing, autos and other consumer durables, by encouraging a more competitive dollar to increase net exports, by raising share prices that increased both business investment and consumer spending, and by freeing up spendable cash for homeowners with adjustable rate mortgages”Except for the increase in next exports, this sounds like a recipe for restoring the unsustainable status quo ante. And it is not at all obvious that, given the boost Marty wants to give to private consumption and investment demand, there would be any reduction in the
In my view, given that increasing the US national saving rate is (a) necessary and (b) practically inconceivable without an economic slowdown and a possible recession in the US, it is better to have the slowdown now, while the world economy is still booming, than to wait until the world economy too slows down significantly. It makes no sense to call for higher private saving and then, when you are at last likely to get what you want, to ask for measures to boost private consumption.
Finally, from my perspective, risk-based “decision theory” would lead to the opposite conclusion from the one reached by Marty. He believes that the risk that the economy could suffer a very serious downturn should dominate the risk of higher inflation. I disagree. The Fed’s triple mandate (maximum employment, stable prices and moderate long-term interest rates) does not support any asymmetric treatment of risk to the real economy and risk to inflation (in the UK and in the eurozone, the central bank mandates are lexicographic, with price stability taking precedence over real economy objectives). So the question is: what would be a worse outcome - a deep recession or a loss of inflationary credibility? I would argue that the risks to price stability and to the anti-inflationary credibility of the Fed should take precedence over the risk of a deep recession. Recessions tend to be short. Restoring anti-inflationary credibility is a long-drawn out and costly process.
Clearly, if the current state of the economy is such that interest rate cuts would support the real economy without raising the risk of boosting inflation above the (implicit or explicit target rate), there is no short-run trade-off, no dilemma and no need for risk-based “decision theory”. Unfortunately, I don’t think were are in such a welcoming environment. Gauging the risk to price stability not from the Fed’s will ‘o the wisp indicator of core inflation but rather from the underlying behaviour of headline inflation, US inflation has been above the Fed’s comfort zone for five years. Unit labour cost growth is rising, quite likely a reflection of a decline in productivity growth that is not just cyclical.
To play fast and loose with inflation at this point risks undermining all that has been achieved since Volcker took over as Chairman of the Fed. This is even more pertinent because the Fed has a new Chairman whose first real test this is. Should he choose to act in a way that undermines the credibility of the Fed’s commitment to price stability, and should this lack of credibility get embodied in inflation expectations and long-term contracts, the cost of regaining virtue would be much higher than the cost of having a slowdown or even a recession now.