Friday, May 6, 2022

The Fed's Can Opener

The Fed talks as if "the neutral rate" is 2.5% and they just need to get the Fed Funds rate up to that and all will be fine.   As Larry Summers points out this is a logical error very much like the joke about economist assume we have a can opener

Joke from Wikipedia:  President Ronald Reagan told the joke to students and faculty at Purdue University on April 9, 1987 saying: "It seems an economist, a chemist, and an engineer were stranded on a desert island. And between them they had only a single can of beans, but no can opener. The engineer suggested that he climb a palm tree to a precise height, then throw the beans at a precise distance, at a precise angle. 'And when the can hits,' he said, 'it will split open.' 'No,' said the chemist. 'We'll leave the can in the sun until the heat causes the beans to expand so much the can will explode.' 'Nonsense,' said the economist. 'Using either method we'd lose too many beans. According to my plan, there will be no mess or fuss and not a single bean will be lost.' Well, the engineer and the chemist said, 'We're certainly willing to consider it. What's your plan?' And the economist answered, 'Well, first assume we have a can opener.'"

From transcript of Powell's May 4, 2022 press conference and video:

"And the current estimates on the Committee are sort of two to three percent. And also, that's a longer-run estimate. That's an estimate for an economy that's at full employment and two percent inflation. So really the way, really what we're doing is we are -- we're raising rates expeditiously to the -- what we see as the broad range of plausible levels of neutral."

They are assuming there is no inflation in their target estimate of the "neutral rate",  even though in the real world we have high inflation.  This is wrong.    It is like the joke, "first assume we have no inflation, then we just need to get rates to 2.5%".  

They have not given us an estimate of the neutral rate for the real inflation conditions we are in, let along a rate that would tame inflation. 

Their mandate is to maintain stable prices and in their plan they are just assuming  we have stable prices.  This is crazy bad.  They are not doing their job. They are not taking the tough steps needed to get from where we are to stable prices.  To lower inflation you need to get interest rates above the inflation rate.   In the real world we have high inflation and even 2.5% will still be a very negative real rate and so stimulative, not neutral.  Many months inflation has gone up 0.5% or more and the Fed has ruled out raising rates faster than that.   They are far behind and it is not clear they will ever catch up.  Runaway inflation is a real possibility.



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