Larry Summers Says the Fed Should Move Fast to Cut Rates

The European Central Bank and the Reserve Bank of Australia have announced more monetary stimulus. Larry Summers says the Fed should follow suit, in his latest Washington Post op-ed:

The best way to take out recession or slowdown insurance would be for the Fed to cut interest rates by 50 basis points over the summer and by more, if necessary, in the fall. A serious recession anytime in the next few years would encourage populism and polarization at home, and reduce American influence and strength in the world as well as damaging the global economy. It is clear in retrospect that the Fed was too slow in responding to gathering storms during 2008 as the Great Recession took hold and in 2000 when the Internet bubble collapsed.

I make the point in “Next Generation Monetary Policy” that most central banks act too slowly in general: they should move interest rates faster and further, being quickly ready to reverse course so they don’t have to be afraid of overshooting.

Larry Summers is doing more than saying the Fed should move fast in general. He is arguing for a rate cut as insurance. Larry gives three key arguments. One is that the economy we are seeing now is what we get when the markets indicate that they are expecting rate cuts. The economy conditional on no rate cuts is worse than what we see. Another argument is that inflation expectations are not convinced that the Fed is serious about its 2% inflation target. In the last few months, Fed officials are being crystal clear in their words that 2% is intended to be a symmetric target. For example, from the Wall Street Journal article “Low-Inflation Trap That Ensnared Japan and Europe Worries Fed” by Nick Timiraos

“We’re trying to think of ways of making that inflation 2% target highly credible, so that inflation averages around 2%, rather than only averaging 2% in good times and then averaging way less than that in bad times,” Fed Chairman Jerome Powell said in February.

But the markets are brushing that off in their long-run inflation predictions. Larry points out:

… market expectations as reflected in Treasury index bonds are for inflation on the Fed’s preferred measure to remain in the 1.5 range even over a 30-year horizon and to be even lower over shorter horizons. 

One can argue over the inflation target the Fed should set, but whatever they say the target is, if markets don’t believe them, that is a problem.

Larry’s other argument is that we have to nip any potential recession in the bud because the Fed may be slow to use deep negative interest rates:

… the Fed normally cuts rates by a cumulative 5 percentage points in response to recession, and with rates now below 2.5 percent there is nothing approaching that amount available. Allowing a recession with inadequate firepower to confront it risks “Japanification” — a situation where interest rates are permanently pinned at zero and deflationary pressures take hold. The Fed will be able to do too little in combating the next recession, so it is especially important that it’s not too late.

I agree. Until I can trust that central banks will, in fact, use the kind of vigorous negative interest rate policies that Ruchir Agarwal and I lay out in our IMF Working Paper “Enabling Deep Negative Rates to Fight Recessions: A Guide,” I want them to avoid getting into a situation where they would need to do so to get a good outcome. Every year that passes is likely to make it seem easier for central banks to implement vigorous negative interest rate policies. If we can just avoid a serious recession in the meantime … (I am very eager for central banks to implement alternative paper currency policies at a very small dosage—say minus 5 basis points for the effective nominal rate of return on paper currency for a year or so) to demonstrate that they can, and to work out technical details. But I would be glad if the need to use negative interest rate policies in a big way—for example, minus 5 percentage points—can be put off for a while longer.)

Larry Summers was one of my professors at Harvard. I have known him a long time. I have talked to him on more than one occasion about negative interest rate policy. He understands the ideas well, and has them in his own view of contingency plans. (See “Peter Sands and Larry Summers Say Deep Negative Interest Rates Are Feasible from a Technical Point of View.”)