Interest rates

Know the interest rates

By shifting from a balanced concern for inflation and jobs to a full-fledged focus on price stability, the Fed is essentially admitting that its inflation critics have been right: it is behind the curve. Striving to catch inflation before it spirals out of control, the Fed is still not going as far as these critics deem necessary.

One of the fiercest critics is former Treasury Secretary Larry Summers. A brilliant economics doctor with a combative style, Summers has stirred up, and at times courted, controversy throughout his long career in academia and public service.

Henry Kissinger once suggested to the White House that Summers be tasked with fighting bad ideas. (https://www.nytimes.com/…) In 2013, President Barack Obama wanted to nominate him as Fed Chairman, but Summers withdrew his name when it became clear that Senate confirmation was in doubt. (https://www.nytimes.com/…)

Recently, Summers launched an attack on Powell’s Fed in two opinion pieces in the Washington Post. In these, he argued that the key to fighting inflation is to raise “real,” or inflation-adjusted, interest rates.

With inflation currently hovering around 7% and the Fed’s benchmark rate below 0.5%, real rates are deeply negative. If Fed officials are correct in predicting that by the end of 2023 their benchmark rate will be 2.75% and the inflation rate 2.6%, the real benchmark rate would be slightly higher than 1%.

Summers doesn’t think inflation will drop that much. In an opinion piece, he suggested that inflation would be around 5% two years from now, meaning the Fed’s forecast benchmark rate would still be negative by a few percentage points. (https://www.washingtonpost.com/…)

In a second op-ed, Summers wrote that real rates “will probably have to reach levels of at least 2 or 3 percent to get inflation under control. With inflation above 3%, that means rates of 5% or more — something that markets currently view as almost unimaginable.”

He is right about one thing. The markets are indeed not expecting rates at the levels he predicts. They always seem to assume that inflation will decline over the next two years. Summers derided the markets’ lack of imagination. (https://www.washingtonpost.com/…)

Could the stock market be foolishly optimistic, as Summers suggests? It’s already arrived. But the bond market?

Bond investors, by definition, are hypersensitive to the possibility of inflation. They are lenders, and inflation means they are repaid in devalued dollars. If they were expecting inflation so virulent that it forced the Fed to adopt interest rates above 5%, their fears would be reflected in the movements of the bond market.

Instead, wrote Matthew Winkler in The Washington Post, these moves suggest that “people buying and selling Treasuries around the world aren’t anticipating an acceleration in inflation over the long term.” (https://www.washingtonpost.com/…) Winkler is someone to take seriously. He spent many years covering the bond market for The Wall Street Journal before joining Bloomberg, where he served as editor from 1990 to 2015.

Winkler said investors in government securities “are betting fortune and reputation on the belief that inflation will spike over the next two years and then decline precipitously at some point over the next eight years… “.

Now granted, I haven’t seen any of the Fed’s defenders, including Winkler, address Summers’ real interest rate argument. Essentially, Winkler and the host of high-profile economists he cites to support his view simply think the Fed shouldn’t drive rates up sharply until the bond market signals panic.

Or, as Winkler put it, “The best-case scenario is for the Fed to raise interest rates when market and financial conditions actually demonstrate that it is truly behind.”

Fed policymakers will have to decide whether Summers or Winkler are right — and take their chances with the outcome. If they need a summary of two conflicting points of view, they are clearly sketched in the competing headlines of The Washington Post.

Summers’ op-ed: “The stock market liked the Fed’s plan to raise interest rates. Wrong.” https://www.washingtonpost.com/…

Winkler: “Are you saying the Fed is behind the curve? Prove it. (https://www.washingtonpost.com/…)

Urban Lehner can be contacted at urbanize@gmail.com