What the Fed should do
In this commentary Larry Summers argues that the Fed’s current policy trajectory is likely to lead to stagflation. Instead what needs to be done is:
Central to success in fighting inflation is establishing credibility that a new paradigm is in place. Recognizing failed strategies, and then abandoning them, is the first step. I hope the Fed will make clear that inflation reduction is its principle objective, and that it will wind down efforts to promote worthy but nonmonetary goals such as social justice and environmental protection. This implies committing to doing whatever is necessary with interest rates to bring down inflation, including movements of more than a quarter-point at some meetings and a rapid reduction of its balance sheet. It also means recognizing that unemployment is likely to rise sometime over the next couple of years.
Paul Volcker would not have had to put the economy through the wringer if his predecessors had not lost their focus on inflation. To avoid stagflation and the associated loss of public confidence in our country now, the Fed has to do more than merely to adjust its policy dials — it will have to head in a dramatically different direction.
The Fed is charting a course to stagflation and recession
By: Larry Summers – Harvard University
Could the Fed be right?
John Cochrane looks at a static IS curve and a Phillips curve with either adaptive or rational expectations. He argues:
If we put the Fed’s interest rate path in the adaptive expectations model, with no further shocks, and fire it up starting with a 5.5% inflation rate, inflation spirals away. This is a plausible model that Taylor, Summers, and other Fed critics may have in mind. On the other hand if we put the Fed’s interest rate path in the rational expectations model, with no further shocks, and fire it up starting at a 5.5% inflation rate, inflation gently settles down. We obtain a path quite close to the Fed’s inflation forecast. If you want to know “what model underlies the Fed forecast,”–how do we model the Fed’s model– the rational expectations version is a much better match.
Using the adaptive expectations model, if the Fed wishes to see its inflation forecast come true, it needs an 8.5% interest rate, right now. (Starting at 5.5% inflation.) The resulting high real interest rate brings inflation back down again. But in the rational expectations model, the interest rate can stay low, indeed even a bit lower than the Fed’s own projections.
Is the Fed Fisherian?
By: John Cochrane – Hoover Institution
