It all started with an article about a speech by Dallas Fed President, Richard Fisher, in the Business Insider last Friday. Mr. Fisher basically said that wages could start rising once unemployment hits 6.1%. He then said that the Fed should start raising the effective Fed rate earlier than projected. The idea is that the Fed should get ahead of wage inflation before it affects price inflation.
Then Tim Duy and Brad DeLong replied to Fisher’s view. They say that the Fed rate should not cut wage inflation short before it even starts. As Duy and DeLong say, we should actually strive for a 4% wage inflation alongside 2% price inflation.
Slow and Gradual is the Key
But there is an idea from Mr. Fisher that both Tim Duy and Brad DeLong did not address. Here is what Mr. Fisher said at the end of the article in the Business Insider…
“”I’d like to do it in a slow and gradual way, rather than rapid and sharp,” he said. “Historically within the Fed, whenever we’ve waited til we believe we are at some measure of full capacity utilization and then we’ve raised rates, every time we’ve done it we’ve brought about a recession.”
Mr. Fisher’s concern is waiting too long to raise rates, and then having to do it too fast. So he prefers to start raising rates early and proceed more slowly. Isn’t he being wise or at least proactive?
On the other hand, do Duy and DeLong prefer the risk of having to raise rates too fast later? Yes, they do. But wouldn’t that cause a recession? Most likely, but it is a risk worth taking.
But then again… as I look into the psychology of the issue, I see a Fed rate that will most likely start rising later than Mr. Fisher would like, and that will rise slowly and gradually even if data warrants a faster rate rise. The Fed does not want to trigger a recession. So they will always keep the Fed rate on the low side… ALWAYS. Is this wise?
Will a higher Fed rate cause a contraction? Will a lower Fed rate keep the economy healthy?
Let’s read a little Keynes… Chapter 22 of General Theory
“But I suggest that a more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital… Moreover, the dismay and uncertainty as to the future which accompanies a collapse in the marginal efficiency of capital naturally precipitates a sharp increase in liquidity-preference — and hence a rise in the rate of interest. Thus the fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the rate of interest may seriously aggravate the decline in investment.”
Tim Duy posted graphs that wage inflation does not really lead to price inflation. So the Fed rate need not respond to wage inflation. Keynes points out that the Fed rate would respond instead to liquidity-preference resulting from “dismay and uncertainty” about the future. Yet that combination “aggravates the decline in investment”. So the solution would be just to keep the Fed rate low, as Duy and DeLong say.
“Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.”
Duy and DeLong would agree with this view. They see Fisher calling for a permanent “semi-slump”. Whereas they are preferring a permanent “quasi-boom”. Yet Fisher’s concern is that eventually there is a recession, and it is best to go into it cautiously with gradually rising interest rates, instead of rates that are too low to respond effectively to a crisis. If rates are too low going through a recession, it will be very difficult for monetary policy to cultivate socially efficient investments, not that they are at the moment, but still, investments would be even more socially inefficient.
“Furthermore, even if we were to suppose that contemporary booms are apt to be associated with a momentary condition of full investment or over-investment in the strict sense, it would still be absurd to regard a higher rate of interest as the appropriate remedy. For in this event the case of those who attribute the disease to under-consumption would be wholly established. The remedy would lie in various measures designed to increase the propensity to consume by the redistribution of incomes or otherwise; so that a given level of employment would require a smaller volume of current investment to support it.”
“Moreover, I should readily concede that the wisest course is to advance on both fronts at once. Whilst aiming at a socially controlled rate of investment with a view to a progressive decline in the marginal efficiency of capital, I should support at the same time all sorts of policies for increasing the propensity to consume.”
So if we were to combine a persistently low Fed rate with higher real wages to distribute income to labor, we should be able to avoid a recession and keep growing. I think Duy and DeLong would be happy with this approach.
But what constitutes a “socially controlled rate of investment”? Well, as the marginal efficiency of capital decreases, interest rates should rise wisely to keep investment from becoming socially inefficient. China looks to have this problem after years of financial repression to favor over-investment. But are the low rates in the US creating this problem? Well, it would be nice and ideal to have the Fed rate reach at least 3% at full-employment. Then the natural real rate is balanced, and investments would be socially balanced. However, if the Fed plans to start raising the Fed rate next summer, and then increase it by 25 basis points per quarter, the Fed rate will reach 3% in 2018. Hopefully the stock market can maintain its record-setting pace for 4 more years.
Nipping in the Bud?
In the end, it seems that Fisher envisions a Fed rate reaching that 3% at full-employment, while Duy and DeLong envision a Fed rate below that, due to having to keep the Fed rate from rising too fast and triggering a contraction. Fisher wants to nip price inflation and inefficient investment in the bud. Is it at all possible that Keynes could agree with Mr. Fisher?
“If we rule out major changes of policy affecting either the control of investment or the propensity to consume, and assume, broadly speaking, a continuance of the existing state of affairs, it is, I think, arguable that a more advantageous average state of expectation might result from a banking policy which always nipped in the bud an incipient boom by a rate of interest high enough to deter even the most misguided optimists. The disappointment of expectation, characteristic of the slump, may lead to so much loss and waste that the average level of useful investment might be higher if a deterrent is applied. It is difficult to be sure whether or not this is correct on its own assumptions; it is a matter for practical judgment where detailed evidence is wanting.”
It seems here that Keynes would side with Fisher’s desire for a gradually rising Fed rate for social balance and efficiency in the economy.
So the debate will continue. Should the Fed rate nip in the bud socially inefficient investments and the prospect of inflation? or Should the Fed rate stay low to encourage investment and consumption for a quasi-boom? Will a low Fed rate even prevent a recession if income distribution does not raise the propensity to consume through a higher labor share? Will the marginal efficiency of capital run its course sooner than wage inflation takes off?
To wrap up: Keynes was able to see both sides of this issue… Either way, I would choose a gradually rising Fed rate. I think Duy and DeLong would too. But is there enough time left in the business cycle to get the Fed rate to a socially optimum level by keeping the Fed rate low? I don’t think so, and that shortfall would haunt us for years.