Larry Summers

In January 2012, the FOMC started to publish its “dot plots” showing the committee’s median expectation for the fed funds rate several quarters ahead. Ever since then, it has become customary to compare the Fed’s dots with the market’s forward pricing for the funds rate over the relevant horizon. Frequently, the dots have been much higher than the market pricing, and this has usually been taken as a signal that the market expects a more dovish stance for monetary policy than implied by the FOMC.

Lawrence Summers recently took this argument a step further, arguing that the gap between the dots and the market’s path for rates suggests not only that the Fed will not, but should not, raise rates. He believes that the dot plot comparisons show that investors do not see sufficient justification for a monetary tightening in the near future. In supporting evidence for this, Professor Summers points to the forward path for inflation built into the inflation-linked bond market, which is also much lower than the inflation path predicted by the FOMC.

It does not normally pay to disagree with Larry Summers, and he may well be right about the immediate future for Fed policy. Inflation is clearly coming in lower than expected.

Nevertheless, it is worth examining the Summers argument in greater detail, since the existence of risk (or term) premia in the market’s forward pricing for interest rates and the inflation rate can scramble the message that investors should take from these readings. Read more

How rapidly should governments correct their fiscal deficits, which in the long run are unsustainable in the US, UK, Japan and many countries in the eurozone?

That is a question which continues to dominate the policy debate among economists. Rapid correction undoubtedly damages near term economic growth, but is intended to reduce the risk of a sovereign debt crisis coming suddenly out of the blue. Slow correction does the opposite. There is no theoretically “correct” policy on this. The result depends on how the near term loss of output should be weighed against the risk and consequences of a fiscal crisis, which is an empirical matter. (See this earlier blog: Assessing the risk of a financial crisis, which attempts to measure the risk of fiscal crisis.)

It is possible for reasonable economists to disagree about this, and for the “right” policy to be different in different countries. However, occasionally a piece of research comes along which changes the “dial” on the debate, and I believe that applies to the important Brookings Paper published last week by Brad DeLong and Larry Summers. This paper, which is well summarised here and here, essentially implies that the trade-off between near-term GDP growth and the probability of fiscal crisis can be irrelevant, because temporary fiscal expansions, at a time when interest rates are at the zero bound, are eventually self-financing.  Read more