The next 3 years will definitely be interesting26th June 2019
[Before starting, let me point to a very interesting new working paper at Mercatus, by Robert Hetzel. He was somehow able to preserve his monetarist perspective while working for decades at the Richmond Fed. Lots of interesting discussion of how the Fed needs to make the rate setting process clearer. In addition, I have a new piece on the Fed, at The Hill.]
Given that the past 10 years have seen a pretty boring recovery, how can I be sure that the next 3 years will be interesting? Because one of three things must happen:
1. A dramatic change inflation, to a rate far from 2%
2. A recession
3. Continued growth with 1% to 3% inflation
The first two are obviously interesting. But why the third?
It turns out that the US has never had a soft landing. Other countries have, but not us. We’ve never had three years of low inflation growth once unemployment fell to cyclical lows.
Consider the following claims:
1. Inverted yield curves predict recessions. (True)
2. Tight money causes recessions. (True)
3. Inverted yield curves show that money is too tight. (False)
It would seem like if the first two claims were correct, then the third claim would also be true. But that’s not the case.
The 3 month/10 year yield spread inverted slightly in September 1966, May 1989, September 1998 and January 2006. In 2 of those 4 cases a recession occurred within two years. But in none of those 4 cases was monetary policy clearly too contractionary at the time. Even in May 1989 and January 2006, the actual policy mistakes occurred a year or more later.
Today the inverted yield curve shows that there is a heightened risk of recession. That’s true. But that doesn’t necessarily mean that money is too tight.
Nonetheless, monetary policy is slightly too tight, as a bit easier money would help reduce the risk of recession without causing inflation to overshoot the 2% target. Policy is not far off course, but it is a bit too tight.
On balance, I believe the most likely outcome over the next three years is a soft landing, although the risk of recession is probably at least 30%. I view the risk of high inflation as being well under 10%.
This rather optimistic take is based on several factors:
1. Previous recessions were often triggered by tight money policies aimed at restraining inflation. I see little risk that the Fed will adopt tight money for that reason. It might adopt tight money for some other reason, like inertia in adjusting the policy rate to the fast moving equilibrium rate.
2. It seems to me that we are nearing a major turning point in the zeitgeist. Policy was dovish in the 1960s and 1970s, because people thought dovish policy was appropriate. That view gradually became discredited, and then policy became hawkish in the 1980s. The hawkish era now seems to be ending, partly because the recent predictions of the doves have been consistently more accurate. Over time, the hawkish warnings about inflation get tuned out, especially by the younger generation.
James Bullard’s recent dissent is a straw in the wind. Bullard has taken both dovish and hawkish stances at various points in time. His recent advocacy of policy easing is one indication that this view is ascendant.
These changes in the zeitgeist are associated with changes in policy, with a lag. The easy money of the 1960s came several years after President Kennedy called for faster growth, and the tight money of the 1980s came several years after Volcker was appointed. While monetary policy is inertial, when it turns the new trend often lasts for decades. I’d expect the next few decades to feature a Fed bias towards dovishness.
I also believe that the Fed learns something from its mistakes. After WWII, they did not repeat the errors of the post-WWI period. After the 1970s, they did not repeat the mistakes of the Great Inflation. I suspect that the Fed has learned some lessons from the Great Recession. They won’t formally adopt NGDPLT, but they will quietly try to make sure that NGDP follows a path that is not too far from what NGDPLT would call for. (Just as inflation targeting was adopted informally, long before it was adopted formally.) Deep down they probably understand that NGDPLT would have done better in 2008-09. Again, Bullard is ahead of the curve.
The biggest risk of recession comes from a “shock”. In the past I’ve argued that the housing/banking shock of 2008 did not cause the Great Recession; tight money was to blame. At the same time, it’s clear that the tight money error would have been much less likely to occur if we had never had a financial crisis. In this case I see two possible shocks that might cause the Fed to screw up:
1. A Eurozone crisis, probably triggered by Italy leaving the Eurozone.
2. A major trade war (which I do not expect to occur.)
I suppose a war with Iran might qualify, but I have trouble seeing how that could trigger a recession. They no longer export much oil.
Brexit is also a possible flashpoint. Ironically, I believe the biggest risk here is that Brexit goes well. If it is seen as going well, it might encourage the Italians to leave. That would probably destroy the euro. I just can’t see how the other weaker Eurozone members could withstand a run on their financial systems if Italy left. In the long run, Europe might be better off without the euro. But as we saw in 1931, the short run impact is contractionary when one country leaves this sort of regime.
Thus Macron will be very tough with Boris, pour encourager les autres.
PS. The current ruling party in Italy was founded by a clown. The new Ukrainian leader is a comedian. And now another clown looks set to become the new British PM.
And let’s not even talk about the USA . . .
As Marx said; history repeats itself, the first time as tragedy, the second time as farce. I’m sure glad to be living in the farce era.
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