Lawrence Summers is a professor at and past president of Harvard University. He was treasury secretary from 1999 to 2001 and an economic adviser to President Obama from 2009 through 2010.
Federal Reserve officials have held out the prospect that at long last they may raise interest rates at their September meeting, with the hike taking effect by year’s end barring major unforeseen developments. A reasonable assessment of current conditions suggests that raising rates in the near future would be a serious error that would threaten all three of the Fed’s major objectives: price stability, full employment and financial stability.
The Fed, like most central banks, has operationalized price stability in terms of a 2 percent inflation target. The dominant risk of missing this target is to the downside — a risk that would be exacerbated by tightening policy. At present, more than half the components of the consumer price index (CPI) have declined over the past six months for the first time in more than a decade. Core CPI (excluding volatile food, energy and difficult-to-measure housing) is rising at less than 1 percent, and the most recent comprehensive measure of inflation costs rose at an annual rate of 0.7 percent over the past quarter. Critically, market-based measures of inflation expectations over the next decade suggest that it will be well under 2 percent. If, as now seems likely, the currencies of China and other emerging markets further depreciate, downward pressure on U.S. inflation rates will increase.
There can be no question that tightening policy will adversely affect levels of employment as higher interest rates make holding onto cash more attractive relative to investing. Higher interest rates also will increase the value of the dollar, making U.S. producers less competitive and pressuring the economies of our trading partners. This is especially troubling at a time of rising inequality. Studies of periods of tight labor markets such as the 1960s and the late 1990s make clear that the best social program for disadvantaged workers is an economy where employers are struggling to fill vacancies.
There may well have been a financial-stability case for raising rates 6 months or 9 months ago, as low interest rates were encouraging investors to take on risk and businesses to borrow money and engage in financial engineering. Even at that time, I believed that the economic costs of a rate increase exceeded the financial-stability benefits, but there were grounds for concern about the medium-term impact of low rates on financial stability. That debate is now moot. With credit spreads significantly increasing, the Chinese outlook clouded at best, emerging markets submerging, the U.S. stock market in a correction, widespread concerns about liquidity and expected volatility having increased at a near record rate, markets are self correcting any euphoria or overconfidence; the Fed does not have to do the job. At this moment of considerable fragility, the risk is that a rate increase will tip some part of the financial system into crisis with unpredictable and dangerous consequences.
In the face of these considerations, why do so many inside and outside the Fed believe that a rate increase is necessary? I doubt that if rates were now 4 percent there would be any great pressure to increase them given current economic conditions. The pressure to increase them comes from a sense that the economy has normalized during the 6 years of recovery and so the extraordinary stimulus represented by 0 percent interest rates should be withdrawn. This has been a consistent theme for the Fed, with much talk of “headwinds” that require low interest rates now but will abate in the not too distant future, allowing for normal growth and normal interest rates.
Whatever merit the theory of temporary headwinds had a few years ago, it is much less plausible as we approach the seventh anniversary of the collapse of Lehman Brothers. It is no longer easy to think of plausible temporary headwinds. Fiscal drag is over. Banks are well capitalized. Corporations are flush with cash. Household balance sheets are substantially repaired.
Much more plausible than “temporary headwinds” is “secular stagnation” or the very similar idea that Ben Bernanke has put forward of a “savings glut.” Headwinds are not temporary but rather the new reality. For a variety of reasons rooted in technological and demographic developments and reinforced by greater regulation of the financial sector, the global economy has more difficulty generating demand for all that can be produced. Satisfactory growth, if it can be achieved, requires very low interest rates that historically we have seen only during economic crises. This is why long-term bond markets are telling us that real interest rates are expected to be close to zero in the industrialized world over the next decade.
New conditions require new policies. There is much that should be done, like major steps to promote both public and private investment, to raise the level of real interest rates consistent with full employment. But until and unless these new policies are implemented, inflation sharply accelerates or euphoria in markets breaks out, there is no case for the Fed to adjust policy interest rates.