Overheating forecast bleg
By Scott Sumner
I have a favor to ask the readers of this blog. I’m looking for articles warning that the US economy is likely to overheat in the next year or two, and that the Fed needs to raise interest rates to prevent such overheating. Please leave a few links in the comment section of this post.
Perhaps some readers are thinking to themselves, “Is this guy crazy? Nobody thinks the economy is about to overheat, or that the Fed needs to raise interest rates. What a silly request!”
Well I may be crazy, but this is a very reasonable request. If the request seems crazy, perhaps it’s an indication that our policymaking apparatus is crazy.
Even in 2009, there were plenty of articles warning that QE would lead to runaway inflation. I’m not sure about you, but right now I’m not seeing any articles warning of economic overheating. And that’s not how things should be.
At any given moment, there will be a distribution of views regarding future growth in prices, NGDP, employment, etc. When the Fed is doing its job, producing a sensible policy consistent with the consensus views of well-informed people, you’d expect roughly equal numbers of people warning that aggregate demand will be too low to hit the 2% inflation target, as those forecasting excessive growth in aggregate demand and high inflation. That’s how it should be.
So why don’t forecasts seem symmetrical right now? Why are so many people currently predicting slower growth ahead and/or requesting a Fed rate cut? Why not a balance of views?
The real problem is something that might be called “monetary policy illusion”. This is actually a set of closely related illusions—the view that:
1. Interest rates are monetary policy.
2. Interest rates should be adjusted infrequently, and by large amounts (at least 25 basis points.)
3. The hurdle to overcome before adjusting interest rates is much higher when the Fed has not been warning the markets to expect such a change, and in that case the Fed should be quite reluctant to change its interest rate target.
Here’s an illusion free monetary regime:
1. Monetary policymakers realize that interest rates are not monetary policy, and that expected NGDP growth best measures the stance of monetary policy. To the extent that interest rates matter at all, it’s the gap between the policy rate and the equilibrium rate that matters.
2. Interest rate targets should be adjusted daily to the closest basis point, not the closest quarter point. The Fed should follow the equilibrium (or neutral) interest rate.
3. Rate changes should be unpredictable a few days ahead, just as changes in market rates are unpredictable a few days ahead. (Of course changes may be predictable given the news of that day.)
The coronavirus has the potential to be a major real shock, and stocks would have fallen significantly this week even under an ideal monetary policy. But I suspect that a significant portion of the decline was due to worry that the Fed would not reduce rates as fast as the equilibrium rate is falling, and as a result NGDP growth would slow, risking a recession.
Some people may disagree, and worry that the economy is about to overheat.
But where are they?