But if rates are at 5% or 6% and you think they might one day go back down to 2%, except you think they could jump to 15% before they fall, it’s hard to know what to do.
If interest rates are at 2% it's a no brainer that you're getting a fixed-rate mortgage. Schrager: This creates a lot of uncertainty for the consumer. But if inflation is at 10%, and the Fed raises interest rates to 15% and car loans are up to 15%, then families will have conversations like, “Sorry, we just can't buy a car right now, we have to wait until the economy settles down and interest rates get back to normal levels.” Negative inflation-adjusted rates make it appealing for people to borrow and for businesses to ramp up their investment. If inflation is 10%, you get a 10% raise at work and mortgage rates are 5% or 6%, then that’s not so bad. Levin: What really matters is interest rates after inflation. Schrager: If we do get short-term rates to 5% or 6%, what does that mean for the average person? Mortgage rates have already risen above 5% will they go up more? One way or another, we need to bring inflation back down to 2%. It’s not good for prosperity and growth and equity. And then the Volcker option becomes necessary because it's not acceptable to the general public to end up with an inflation rate close to double digits. And that will make it that much harder because inflation gets baked into wages. Of course, if the Fed takes too long to move to neutral, then the inflation situation could continue to deteriorate. Either way, the Fed needs to have a clear strategy and it needs to engage in scenario analysis and contingency planning. Last week’s report on domestic demand of private consumers and businesses was very strong it's actually accelerating. If those geopolitical risks materialize we could be facing a very different situation in the second half of the year. There are geopolitical risks at work right now. We are in unchartered territory coming out of the pandemic. We have to be attentive to risks, and there are many. And then we’ll see where we are and see whether or not we can get away with the Greenspan option or if we have to go with the Volcker option. Schrager: So you’d suggest we spend the next year getting to a neutral stance, with rates at around 5% or 6%. The options really depend on how it evolves and what consequences are required to bring inflation down. Inflation being entrenched at 6% or 8% or 10% over the next couple of years is a very different situation than if inflation settles at 3% or 4%. Inflation did come down to around 2% and then from that point onward the Fed basically just tried to keep it close to 2%. The opportunistic disinflation was actually successful because of a combination of a number of different events during the first half of the 1990s and into the second half of the decade, including accelerating productivity growth. So he pursued a policy he called “opportunistic disinflation,” which meant, "We're not going to slam on the brakes." But if the economy naturally slows or if there are factors like productivity that bring inflation down, then we will allow that to happen. Inflation was around 4% to 5% then and Greenspan wanted it to come down close to 2%.
The other we can call the Greenspan option, which the Fed followed under Alan Greenspan in the early 1990s. And then the Federal Reserve was able to ease off the brakes and we actually had a strong recovery in 19 and, in fact, by 1984 people were singing “happy days are here again” because the economy was growing and inflation was much lower again. And that means the Fed could still be adding fuel to the inflationary inferno, even by the end of this year.īut that caused the economy to contract very sharply and we had a very severe recession - the worst recession in the post-World War II era.
He appeared to take the possibility of a 75-basis-point increase off the table, preferring to stick with smaller hikes in coming months. Getting to neutral, as Fed Chairman Jerome Powell said himself Wednesday, is still a long way off. Right now the underlying level of inflation is running at about 5% once you take out transitory factors, so the inflation-adjusted interest rate is deeply negative (about -4%). The monetary policy stance is neutral when the federal funds rate is just a bit higher than the underlying trend of inflation. At this stage getting to a neutral rate, where it is no longer pushing inflation even higher, is the top priority. What really matters to the economy is the inflation-adjusted interest rate, which is the rate minus inflation. Andrew Levin: Unfortunately, the Fed is still not following the basic principles of sound monetary policy that it has laid out on its own website.
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