Welcome to Central Bank Central. I'm Kathleen Hayes. Day one of a two -day meeting for the Federal Reserve, the big debate seems to be centered on how big will the cut be? Was they start this rate cutting cycle that's been advertised for so long now?
Will it be a smaller, as someone say, tried -and -true 25 basis cut or will they do the 50 basis point cut that maybe would have some more impact? We're looking a lot at the economy,
inflation, et cetera. But maybe there's some bigger questions that we aren't looking at. And for that, I bring in Adam Pozen. He is president of the Peterson Institute for International Economics.
He has worked for central banks around the world for many decades. So he certainly has not only a Fed perspective, but definitely a global perspective. And first of all, Adam, welcome.
“ The main point I'm trying to make,
Kathleen, is that for two reasons what you said is probably true, that even though we're seeing a little bit of softening in labor markets, it's probably not due to monetary policy,
because monetary policy is better assessed on two lines than what they've been saying. So people have been emphasizing and the Fed has been emphasizing what is literally the Fed funds rate target and then subtracting the CPI and saying,
"Okay, the real interest rate has gone up "because the Fed funds target stayed roughly the same "and inflation's gone up." And to me, that fundamentally misses point in two ways.
The first way is that we normally think of monetary policy as affecting The economy through people's expectations, through financial markets, through liquidity conditions,
not so much directly into labor markets or something else. And when you look at all those, what are called the transmission mechanisms from monetary policy, they all look weak. So spreads between more and less risky interest rates charged availability of credit,
number of bankruptcies, even number of layoffs in the labor market. These are all not consistent with a really tight Fed policy. I'm old enough you may not be to remember when the Fed,
you know, did real tight nings. And in the past, if you did 500 basis points of tightening, you know, unemployment shoots up, but also interest rates spreads widen availability of credit goes way down.
And we just haven't seen that. And you may recall in this, I know you were around for and your listeners were around for a year, a year and a half ago in early 2023, we were talking about why is monetary policy not having an effect because even residential construction,
which usually moves with interest rates didn't seem to move much. The second point, why I think monetary policy is probably not as tight as the Fed seems to think or says is because monetary policy tightness isn't just what the level is,
it's the level with respect to the state of the economy. In the shorthand for this, central bankers talk about something called R -STAR, which Fed chair Powell has spoken about and rightly said you can't measure it,
you can't taste it, it's not a real thing, it's an abstract. But it's a useful concept that the same economy can have differing levels of sort of the basic run rate of interest rates.
And right now, there's a lot of reasons to think that R *, the basic run rate of interest rates, is higher than it used to be. And if it's higher than it used to be, then instead of looking at the Fed funds rate minus the inflation rate,
what you want to look at is the Fed funds rate minus R *. And if R * is going up, that gap's smaller. And if that gap's smaller, Fed policy is not as tight.
- We know, I would say, oh gosh, starting for the past several months, for a while now, I think one of the questions people have had is put very simply,
if policy is so tight and restrictive, why is the economy still doing so well? And we thought today the Atlanta Fed now cast looking at third quarter GDP,
the running estimate is 3 % industrial production and manufacturing came in strong. Retail sales met or topped estimates. They're not roaring, but they're certainly hanging in there.
And you mentioned the labor market, even though the unemployment rate went up at 4 .2 % now, it's some would say it's kind of around the natural unemployment rate. The 3 % was way too low.
So what is the Fed up to here? Why are they so intent on looking at the need to start cutting rates, maybe starting with a jumbo cut? Why are they not looking at the factors you're looking at?
I think there's three things going on. It's a committee, there are different people with different biases. The first is there are a bunch of people who are focused on the labor market,
which is fine, but they seem to be has done very narrow definitions of how you monitor the labor that it really comes down to the unemployment rate and the wage growth. And you might recall,
again, going back into the past, when Janet Yellen was chair of the Fed, she published what she called the dashboard of labor market indicators. There was like 14 different runs. That didn't mean she got it right.
I think the Fed got it wrong and wasn't aggressive enough in trying to get back to full employment in 2014, 2015. But the point was that were things like labor force participation that were almost as important or I would argue should be even more important than the unemployment rate.
And that's one of the big things. As we've seen the unemployment rate come down, the labor force participation, excuse me, the unemployment rate come up, the labor force participation rate has also gone up. We have more people working of prime age and young age.
Young age is still a little influx. So I think the first thing is they have a very big concern about labor market, but they're focused on a narrow set of indicators. The second thing,
which is the part I have most sympathy for, is what we call risk management, which is that they're saying inflation seems to be on a downward path, has been for several months, is going down further,
all else Well, we don't want a recession if we can avoid it. And there seems to be little inflation danger if we act on that. I think that's a reasonable point of view,
but I wish then their communications and frankly reasoning was more explicit. That it's not because we think labor markets are trouble. It's not because we think something's imminent.
It's balance of risks. And that's something that Chair Powell and other FOMC members of the last few weeks have been very. The third point is going back to where you kindly cited my article is I think there are a bunch of people at the Fed on the FOMC who are just religiously focused on this idea that the real federal funds rate is a sufficient were at the state of monetary policies.
There was a lot of discussion several months ago, New York Fed President Williams, Dallas Fed President, Logan, both of whom have market relevant experience talking about how there was a liquidity premium,
there was a term premium, all this jargon to explain why the interest rate was going what it was. And my view formed by the financial crisis is that Again,
in crude form, the Fed funds rate is not a sufficient statistic for financial and monetary conditions. So I wouldn't focus on it so much. Okay, so let's get into that then because one of the things I think you mentioned in this project syndicate piece,
mystery in the impact of monetary policy, and I want to recommend anybody who's listening watching. It's a nice, clear, simple piece. It's not pages and pages. And it will, it will give you things to think about,
to understand how monetary policy, combined with fiscal policy, do how it all works. But when you talk about, I think a lot of people understand financial conditions. If policy is so tight and this economy is gonna head into a recession,
how come the stock market, I mean, it's been down, but it's a long -term rally. And then recently the drop in yields is another source of extra stimulus or certainly not moving away from restrictiveness.
- No, I completely agree with you. And again, thank you for your kind recommendation, but I think whether or not people read my piece, I hope they do, this is the important point that traditionally for good reason,
the Fed has said, we care about monetary transmission. That was actually the topic of this year's Jackson Hole Conference. We care about seeing how when we make a decision involving the short -term interest rate or the Fed's balance sheet,
how it comes out to the economy, how long does it take, what big channels does it go through? And so right now, you've got a situation where the two major channels that people use to talk about,
inflation expectations and financial conditions, are looking looser. So inflation expectations are down. So there's no reason to think that people are expecting a tight legal policy.
And like you said, the stock market, lending, credit aggregates, mortgage rates, they're all maybe not loose loose, but given 500 basis banks of banks,
they ain't tight. Another thing you bring up here, which it seems like it's become more and more important because of all the deductions issuance during the pandemic,
right? Fiscal, fiscal policy. And right now the budget deficit. I think that there's a lot of attention on this for a while, how there was so much stimulus that Fed maybe didn't appropriately take account of,
right? During that time. But it's the deficits are still there and we have two presidential candidates who are not talking about going in the other direction, if anything, under their current rendition of what their policies might be,
the deficit will get bigger. How does this fit into the picture? - I'm glad you pointed that out, Kathleen, because whether it's the Harris campaign or the Trump campaign, both of them, all the neutral assessments are,
they're gonna create large budget deficits over additional beyond the very large ones we already have. Best estimates are the Trump ones would be three times as big as the Harris ones,
which is bad, but the Harris ones are still not great. And I think there's both a short -term and a long -term piece. Now, the long -term piece, which Larry Summers started speaking about about a year and a half,
two years ago, is the idea that we're all committed to lots of spending. We're going to increase defense spending. We're going to increase spending on the green transition. We're going to increase depending on industrial policy,
which I would say is not a good thing, but anyway, and there's no constituency for raising tax access you apply. And so, if you have long term deficits, you're essentially running the Cold War reverses Larry said,
which is you're, you're putting more demand on a fixed pool of savings for the fit to fund your fiscal deficits and that drives up interest rates on average over time.
The short -term version, which is what you mentioned, is that the fiscal policy was appropriately loosened stimulative during COVID when we didn't know what was going to happen.
And when we were spending it on actual COVID relation things, whether it was Project Moonshot or whether it was first responders, those were good expenditures. But we kept it going, kept it going,
even when the economy recovered. Now, to be fair, people like me, Larry Summers, my colleague at Peterson, Olivier Blanchard, Jason Furman, we were wrong. There wasn't as much inflation over the last couple of years because of the deficits as we expect.
Nonetheless, the idea that the economy is going into reverse at a point when the fiscal deficits are so large and are poised to get even bigger,
again, strikes me as odd. And that gets to another point you and I could talk about, which is the Fed is so focused now on the next three months and not taking into account what's likely to happen next year.
- Okay, so let's put those two together because I think probably what you're referring to is if we do have a larger deficit and you think you're going to do all these rate cuts next year and the June dots suggested there'd be what,
the medium is at least 100 basis points of cuts. that's going to get in the way of this idea by the Fed we're just going to gradually be cutting rates and cutting rates and by 2026 will cut the rates a lot and we'll have inflation back down to 2 % they're giving themselves a long,
you know, takeoff to get to that along ramp to get to 2%. Yeah, and this is both a substantive issue and a communication issue. So substantively, I think it's just wrong to say you're you're expecting the dots have essentially codified 75 plus in 2024 of cuts 100 plus in 2020 in 2025 and another 75 to 2026.
So even if you discount 2026. That's a lot. But second, there is this issue of how do you deal with the idea that fiscal policy depends on who's president and the Fed doesn't want to get involved.
And I sat through that when I was at the Bank of England on their committee, and there was an election in 2010, and we had to be careful about that. So it's not easy, but there is something you can say,
which is both candidates are proposing platforms of fiscal that would be expansionary on top of current DoFG deficits and the CBO projections are for nonpartisan or for this.
So no matter what it is, we should expect at least this much fiscal stimulus next year. And we're making no judgments on, you know, composition of tax versus taxes versus spending,
just first order approximation, budget deficits are going to be up three quarters of a percent or more the next two years. And put that in your forecast. And if you don't want to say that,
then I think you're causing more trouble than if you keep your mouth shut. Adam, I want to come back to this point you make in your paper about risk management and how and why it is reasonable,
even if there are some questions about how well the Fed may be reading or misreading the impact of monetary policy on the economy and inflation, that you can get on board with them saying,
we see the risks and we're gonna start down that rate cutting path now. - I think it's perfectly reasonable, Kathleen, for the Fed to say, right now,
the inflation forecast is continued declines. There's very little sign given wages and other and energy and other moves and even rents that inflation is going to restart.
Therefore, given the balance of risks, we rather err on the side of loosening preventive recession. That's fine. Where I get off the train of what they seem to be saying it's two things.
First, you have to be very explicit, or at least you should be very explicit, that risk management means there's a risk to it. So the risk is, if it turns out that unemployment is really just stabilizing in the low fours because three and a half was too low a level to be sustained,
or other things are going on in the economy, like the fact that monetary policy may not be that tight, you have to be prepared for the risk of the economy bounces back faster than you think, and you are putting unnecessary loosening it.
The second thing is you have to communicate that you're willing to turn things around. And central banks hate saying that central banks hate reversing themselves. But in this kind of situation,
it's okay to say, we're going to take this risk in the interest of the public. But in the interest of the public also be prepared that maybe a six months or even three months from now,
we're going to have to stop cutting. And so, put in the fact that there's uncertainty about these extra cuts in 2025. Don't suddenly show up and say,
oh, we had to cut. We had no idea this was all shock. That's not a good way to manage things. Well, the messaging from the Fed right now seems to be we're quite certain even if we move slowly we're going to just continue to move down towards 2 % target where you know others can say well you're kind of if you look at CPI you're at 3 % you know if you look at the deflator you're around two and a half are you
confident that that downtrend in inflation is going to continue as the Fed gets on this path? No I'm not confident I think again it's both a substance and a communications issue On substance,
I think it's unrealistic to go along saying we are pretending that we don't know that fiscal policy will be large and stimulative in 2025. It's already big deficits.
And it may be worse under Trump than under Harris, we can't say as the Fed, but we can predict that it's going to be stimulative by six months from now. And then there's all these other labor market indicators and economic indicators that suggest the economy isn't cratering.
And then all the issues you and I just spoke about about how monetary policy may not be that tight and credit and equity markets and availability of loans and mortgages are all doing.
Okay, so first is just to say, don't act as though because we're getting a couple higher unemployment for a couple of months, that the economy is definitely on the downward path and inflation is definitely on the downward path.
The second is the communications point. Sure, which is much more straightforward. When Ben Bernanke, Thomas Lawbacher, Rick Michigan and I wrote a book on inflation targeting.
We focused on the idea and other central banks practicing inflation targeting focused on the idea that you're targeting a two year ahead forecast, that you can't control what's going on right now.
What's going on right now is the result of things in the past. What you're trying to do is manage what you can control. Now, the Fed right now is focusing all their communications,
not just on a limited set of indicators, but on basically the next three months. And they can say, well, it's because of the election, but I think that's irresponsible. more importantly, I think the Fed's been focusing too much on the short term and backwards looking indicators for several months now.
So if they were saying, we have a forecast for two years now inflation is going to be way down, they should say that. And then if they say that, probably it will be proven to be wrong.
But if they're scared to say that then they shouldn't be pursuing the policy they're pursuing. Okay, well, I just have to wrap this up with 50 basis point cut.
Does this, would this argue against it? If the fed were listening to you and it's all Adam, you're right with that. Did that say we'll do 25 and that's plenty. I think if the fed chose to listen to me, which is likely in this particular moment.
Okay, I think it would be 25, 25, 25. And even some chance you I'm not due to say, but you know, there's been a lot of chatter over the last few days ahead of the meeting about.
Having a 50 point cut, I hope that's not indicative, not so much because it's a huge policy mistake. It's a minor policy mistake. But again,
it would be, they communicated it was all about the labor market and certain measures and the It didn't come out the way they said, and then if they go and do it anyway, I think they're sending a confused message.
Well, and also, I just, I just need a commitment. You're going to come back. You know, we've, this is, this is just all fully unfolding now. There's going to be a lot more going on. And it's so great to have you on the show today.
And I truly look forward to having you again. And again, I'm going to tell everybody at project syndicate. Miss reading the impact of monetary policy. - Thank you so much, Kathleen. Glad to join you on Central Bank Central now or anytime,
thanks. - Okay, I'm Kathleen Hayes. And again, thank you for joining us.
Posen: Fed Rate Cuts Now Risk Rebound of Inflation Next Year