Don’t raise interest rates now
I cannot recall a moment when the gap between what markets expect the Federal Reserve to do and what the Fed has forecast it will do has been as large as it is now. Markets predict that the Fed will raise interest rates to 1.6 percent by the end of 2017; the Federal Open Market Committee’s average forecast is 3.5 percent.
Such a divergence raises the risk of volatility and poses a communications challenge for the Fed. More important, it raises the question of what should guide policy going forward.
The unemployment rate is at its postwar average and continues to fall. Job openings are above their historic average. Other indicators such as the percentage of workers receiving unemployment benefits suggest a normal or rapidly normalizing economy. This would suggest that interest rates should not remain at zero much longer.
On the other hand, the core consumer price index has averaged 1.1 percent over the past six months. Wages fell in December and over the past year employment costs have risen by 2.25 percent, which, with productivity growth of only 1 percent, suggests inflation of below 2 percent. Perhaps most troubling: Market indications suggest inflation is more likely to fall than rise.
The Fed should not raise interest rates until there is clear evidence that inflation is in danger of exceeding its 2 percent target. Here’s why:
First, real wages for most workers have been stagnant. Median family incomes are down by 4.5 percent over the past five years and the size of the economy is about $1.5 trillion below pre-recession estimates. In such circumstances, efforts to reduce demand and growth require a compelling justification.
Second, if inflation were to accelerate a bit from current levels, this would be a good thing. It is now running below the Fed target. Prices are about 4 percent below where they would be if 2 percent inflation had been maintained since 2007. So there is a case for some inflation above 2 percent to catch up to the Fed’s price-level target path. There may also be a case for inflation a little bit above 2 percent for the next few years to allow real interest rates low enough to promote recovery when the next recession comes.
Third, historical experience is that inflation accelerates slowly, so the costs of an overshoot are small and reversible with standard tightening policies. In contrast, aborting recovery and risking a further slowing of inflation is potentially catastrophic. So prudence in avoiding the largest risks counsels in favor of Fed restraint in raising rates.
Fourth, higher interest rates and the stronger dollar they would bring would mean greater debt burdens for debtor countries, a growing U.S. trade deficit that damages manufacturing and growing protectionist pressures. There is already a danger that safe-haven flows will drive the dollar up to the point where the U.S. economy could be slowed.
None of this is to say that rates should never be raised or that inflation indicators might not justify a rate increase before long. It is to say that the Fed could inject much-needed confidence in the economy today and minimize future risks by announcing and following a strategy of not raising rates until it sees the whites of inflation’s eyes.
Lawrence Summers is a professor at and past president of Harvard University. He was Treasury secretary from 1999 to 2001 and economic adviser to President Barack Obama from 2009 to 2010.