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 Obama from 2009 through 2010.
I cannot recall a moment when the gap between what markets expect the Federal Reserve to do and what the Fed itself has forecast it will do has been as large as it is now. Markets predict that the Fed will raise interest rates only 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.
Especially after Friday’s very strong employment report, there can be no doubt that cyclical conditions are normalizing. The unemployment rate is at its postwar average level 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. Taken in isolation, all this would suggest that interest rates should not be allowed to remain at their current zero level much longer.
On the other hand, the available inflation data suggest little cause for concern. The core consumer price index has averaged 1.1 percent over the past six months; if housing costs were stripped out, the figure would be zero. Wages actually fell in December, and over the past year, employment costs have risen by 2.25 percent, which, in conjunction 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 has rightly made clear that its decisions will be data dependent. The further key point is that it should allow the flow of information on inflation rather than on real economic activity to determine its timing in adjusting interest rates. And it should not raise rates until there is clear evidence that inflation, and inflation expectations, are in danger of exceeding its 2 percent target. Here are four important reasons 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 — or $20,000 for the average family of four — below pre-recession estimates of its 2015 potential.
In such circumstances, efforts to reduce demand and growth require a compelling justification. Yet the idea that below-normal unemployment will necessarily lead to accelerating inflation, as suggested by the so-called Phillips curve, is very uncertain. Contrary to such predictions, inflation did not decelerate by much even a few years ago when unemployment was in the range of 10 percent. Nor was there much evidence of accelerating inflation in the 1990s, when the unemployment rate fell below 4 percent.
Second, if inflation were to accelerate a bit from current levels, this would be a good thing. It is now running, and is expected to run, below the Fed target. Prices are about 4 percent below where they would now 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, a plane that accelerates too rapidly as it takes off may cause its passengers some discomfort, while a plane that accelerates too slowly may crash at the end of the runway. Historical experience is that inflation accelerates only 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 — as Japan’s experience over the past quarter-century demonstrates. So in a world where economic forecasts are highly uncertain, prudence in avoiding the largest risks counsels in favor of Fed restraint in raising rates.
Fourth, the United States has never been more intertwined with the global economy. 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, given all the problems in Europe, Japan and emerging markets, that safe-haven flows will drive the dollar up to the point where the U.S. economy could be significantly slowed. Raising rates without evidence of rising inflation could dramatically increase real rates and exacerbate these risks.
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.