The Fed’s Job Is About To Become Much Harder
By Lawrence H. Summers
The Washington Post
The Washington Post
August 14, 2017
With Janet Yellen’s term ending in February, President Trump will have to nominate, and the Senate confirm, a new Fed chair in coming months. There will be much discussion of the merits and implications of various candidates for the job. But it will be important for the president and senators to begin by considering the challenges the next chair will face.
While I would have preferred slower increases in interest rates at key junctures, and believe that the Fed has consistently over-assessed future inflation, growth and monetary tightening, and is too serene about the current robustness of the financial system, the Fed has done very well overall in recent years. We have not enjoyed so favorable a combination of low unemployment and inflation in decades. Markets have been remarkably stable — perhaps even too stable — for years. And the Fed, by the standards of other Washington institutions and central banks around the world, is highly respected. This all is both a tribute to its leadership and a reflection of fortunate circumstance.
I suspect the Fed’s job will become much more difficult over the next few years, however. Economics, finance and politics are all likely to throw up new challenges demanding creative and unorthodox responses.
If history is any guide, it is more likely than not that the economy will go into recession during the next Fed chair’s four-year term. Recovery is now in its ninth year, with relatively slow underlying growth (for both demographic and technological reasons), low unemployment and asset prices that are high by many measures. Even without these factors, there is a 20 percent or so chance that if the economy is not in recession at any given time, it will go into recession within a year. The odds that the next Fed chair will have to address a recession are probably about two-thirds.
Historically, the Fed has responded to recessions by cutting interest rates substantially, with the benchmark Fed funds rate falling by 400 basis points or more during downturns over the past two generations. This time around, it is unlikely that there will be room for this kind of rate cutting. To influence longer-term rates, the Fed will have to improvise through a combination of rhetoric and direct market intervention. This will not be easy given that 10-year Treasurys, whose yield would decline precipitously in response to a recession and any move to cut fed funds, currently yield below 2.20 percent.
In consequence — and to an extent that is underappreciated — the economy is likely quite brittle within the current inflation-targeting framework. Responsible new leadership at the Fed will have to give serious thought to shifting this framework, perhaps by putting more emphasis on nominal gross domestic product growth, focusing more on price level than inflation (so periods of low inflation are followed by periods of high inflation) or raising the inflation target. None of these steps will be easy given current circumstances. And once a recession comes, it will likely be too late.
There has not been a major bout of financial instability or a foreign financial crisis in the past four years. This good luck is unlikely to continue. There are real risks emanating from China, from signs of overvaluation in parts of U.S. equity markets and from buildups in leverage, as well as from a highly disordered geopolitical situation in which U.S. credibility has fallen sharply. After the latest round of stress tests, the Fed asserted that even if the stock market lost half its value, the unemployment rate reached 10 percent and real estate prices fell by as much as they did in the last crisis, all the big institutions would be fine at current capital levels. Market evidence suggests otherwise — based on past patterns, their equity values would collapse.
The challenge with respect to crisis risk will be maintaining the crucial components of Dodd-Frank financial regulation, such as higher capital levels; recognizing serious problems and forcing fortification of capital positions much more quickly than was done in 2008; and, should a crisis come, finding ways in a difficult legal and political environment to avoid the kind of unraveling that followed Lehman Brothers’ failure.
Perhaps the most profound challenges ahead will be political. There must be more risk now of political interference with the Fed than at any time since the Nixon presidency. In dealing with international matters, the Fed is partnered with an understaffed and amateurish Treasury and a president who is busily dissipating U.S. credibility. Most fundamentally, the temper of the times has turned against technical expertise in favor of populist passion — and the Fed is the quintessential enduring apolitical institution.
We all have a great stake in the president making and the Senate confirming the right choice.
With Janet Yellen’s term ending in February, President Trump will have to nominate, and the Senate confirm, a new Fed chair in coming months. There will be much discussion of the merits and implications of various candidates for the job. But it will be important for the president and senators to begin by considering the challenges the next chair will face.
While I would have preferred slower increases in interest rates at key junctures, and believe that the Fed has consistently over-assessed future inflation, growth and monetary tightening, and is too serene about the current robustness of the financial system, the Fed has done very well overall in recent years. We have not enjoyed so favorable a combination of low unemployment and inflation in decades. Markets have been remarkably stable — perhaps even too stable — for years. And the Fed, by the standards of other Washington institutions and central banks around the world, is highly respected. This all is both a tribute to its leadership and a reflection of fortunate circumstance.
I suspect the Fed’s job will become much more difficult over the next few years, however. Economics, finance and politics are all likely to throw up new challenges demanding creative and unorthodox responses.
If history is any guide, it is more likely than not that the economy will go into recession during the next Fed chair’s four-year term. Recovery is now in its ninth year, with relatively slow underlying growth (for both demographic and technological reasons), low unemployment and asset prices that are high by many measures. Even without these factors, there is a 20 percent or so chance that if the economy is not in recession at any given time, it will go into recession within a year. The odds that the next Fed chair will have to address a recession are probably about two-thirds.
Historically, the Fed has responded to recessions by cutting interest rates substantially, with the benchmark Fed funds rate falling by 400 basis points or more during downturns over the past two generations. This time around, it is unlikely that there will be room for this kind of rate cutting. To influence longer-term rates, the Fed will have to improvise through a combination of rhetoric and direct market intervention. This will not be easy given that 10-year Treasurys, whose yield would decline precipitously in response to a recession and any move to cut fed funds, currently yield below 2.20 percent.
In consequence — and to an extent that is underappreciated — the economy is likely quite brittle within the current inflation-targeting framework. Responsible new leadership at the Fed will have to give serious thought to shifting this framework, perhaps by putting more emphasis on nominal gross domestic product growth, focusing more on price level than inflation (so periods of low inflation are followed by periods of high inflation) or raising the inflation target. None of these steps will be easy given current circumstances. And once a recession comes, it will likely be too late.
There has not been a major bout of financial instability or a foreign financial crisis in the past four years. This good luck is unlikely to continue. There are real risks emanating from China, from signs of overvaluation in parts of U.S. equity markets and from buildups in leverage, as well as from a highly disordered geopolitical situation in which U.S. credibility has fallen sharply. After the latest round of stress tests, the Fed asserted that even if the stock market lost half its value, the unemployment rate reached 10 percent and real estate prices fell by as much as they did in the last crisis, all the big institutions would be fine at current capital levels. Market evidence suggests otherwise — based on past patterns, their equity values would collapse.
The challenge with respect to crisis risk will be maintaining the crucial components of Dodd-Frank financial regulation, such as higher capital levels; recognizing serious problems and forcing fortification of capital positions much more quickly than was done in 2008; and, should a crisis come, finding ways in a difficult legal and political environment to avoid the kind of unraveling that followed Lehman Brothers’ failure.
Perhaps the most profound challenges ahead will be political. There must be more risk now of political interference with the Fed than at any time since the Nixon presidency. In dealing with international matters, the Fed is partnered with an understaffed and amateurish Treasury and a president who is busily dissipating U.S. credibility. Most fundamentally, the temper of the times has turned against technical expertise in favor of populist passion — and the Fed is the quintessential enduring apolitical institution.
We all have a great stake in the president making and the Senate confirming the right choice.
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