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Summers: My Views and the Fed’s Views on Secular Stagnation

Larry Summers:

My views and the Fed’s views on secular stagnation: It has been two years since Alvin Hansen’s secular stagnation idea and suggested its relevance to current conditions in the industrial world. Unfortunately experience since that time has tended to confirm the secular stagnation hypothesis. Secular stagnation is a possibility. It is not an inevitability and it can be avoided with strong policy. Unfortunately, the Fed and other policy setters remain committed to traditional paradigms and so are acting in ways that make secular stagnation more likely. ... Indeed I would judge that there is at least a two-thirds chance that we will experience zero or negative rates again in the next five years. ...

I believe its decision to raise rates last week reflected four consequential misjudgments.
First, the Fed assigns a much greater chance that we will reach 2 percent core inflation than is suggested by most available data. ...
Second, the Fed seems to mistakenly regard 2 percent inflation as a ceiling not a target. ...
Third... It is suggested that by raising rates the Fed gives itself room to lower them. ... I would say the argument that the Fed should raise rates so as to have room to lower them is in the category with the argument that I should starve myself in order to have the pleasure of relieving my hunger pangs.
Fourth, the Fed is likely underestimating secular stagnation. It is ... overestimating the neutral rate. ...
Why is the Fed making these mistakes if indeed they are mistakes? It is not because its leaders are not thoughtful or open minded or concerned with growth and employment. Rather I suspect it is because of an excessive commitment to existing models and modes of thought. Usually it takes disaster to shatter orthodoxy. We can all hope that either my worries prove misplaced or the Fed shows itself to be less in the thrall of orthodoxy than it has been of late.

The Fed's job would have been, and will be a lot easier if fiscal policy makers would help. I disagree with Charles Plosser's view on monetary policy, but I have some sympathy for the view that many people have come to expect too much from monetary policy:

... On the monetary policy side central banks have clearly pushed the envelope in an effort to stabilize and then promote real economic growth.  The pressure to do so has come from inside and outside the central banks.  These actions have raised expectations of what the central bank can do.  For the last three or four decades, it has been widely accepted among academics and central bankers that monetary policy is primarily responsible for anchoring inflation and inflation expectations at some low level.  In the United States, where the Fed operates under the so-called dual mandate to promote both price stability and maximum employment, monetary policy has also attempted to stabilize economic growth and employment.  Yet it has also been widely accepted that monetary policy’s impact on real variables was limited and temporary, thus in the long-run changes in money were neutral for real variables.

The behavior of central banks during the crisis and subsequent recession has turned much of this conventional wisdom on its head.  It is not clear that this is wise or prudent.  Many have come to fear that without substantial support from monetary policy our economies will slump into stagnation. This would seem to fly in the face of nearly two centuries of economic thinking. ...

If secular stagnation is real, the Fed cannot overcome it by itself. Fiscal policy will have to be part of the solution. (I do think one statement above is wrong, and it gets at the heart of Summer's recent work reviving hysteresis and his statement above about commitment to orthodoxy. When Plosser says "monetary policy’s impact on real variables was limited and temporary, thus in the long-run changes in money were neutral for real variables," he is ignoring recent work by Summers, Blanchard, and Fatas showing that recessions can permanently  lower our productive capacity, and it is worse when the recession lasts longer. This means that monetary policy -- and fiscal policy too -- can have a permanent impact on the natural rate of output by helping the economy to recover faster. The faster the recovery, the less the natural rate is lowered. So I agree with Summers that monetary policy needs to take the possibility of secular stagnation into account, I just wish he'd put more emphasis on the essential role of fiscal policy -- something he has certainly done in the past, e.g., "I believe that it is appropriate that we go back to an earlier tradition that has largely passed out of macroeconomics of thinking about fiscal policy as having a major role in economic stabilization.")