There are two major opinions concerning what Fed policy. One is the misallocation view. The other is the fragile economy view. These two views are like two ships passing in the night without any acknowledgement of each other's presence. There cannot be agreement on policy action because the view of the world are so different.
With the misallocation view, the Fed has to raise rates because the current zero rate policy is distorting the allocation of capital and that distortion needs to stop. There are bubbles lurking in financial markets and the zero rate policy has been the key driver. The zero rate policy has caused the reach for yield by investors which means more risk-taking than is appropriate for the economy. It does not matter whether there is limited inflation. It does not matter whether trend growth is lower than the pre-crisis levels. The seeds of another crisis are brewing, so rates should be raised now.
In the fragile economy view, the Fed should hold rates low because the economy is still fragile and the Fed should not take the downside risk of raising rates too soon. Rates have to stay low to get the economy out of the current secular stagnation. There is no bubble or financial crisis because the economy is not overheating and inflation is well below the target rate. There may be a distortion but that should lead to more risk-taking and reduce the demand for money.
It is a battle between a real economy view and a financial economy view. The misallocation or financial risk story can point to further increases in leverage outside the consumer. Misallocation view is an argument based on the potential for a crisis. The real economy, secular stagnation, view is based on output gaps and potential GDP. It is a story of economic potential. As long as these world views are so different, it is unlikely we can get agreement on what should be the right Fed policy.
With the misallocation view, the Fed has to raise rates because the current zero rate policy is distorting the allocation of capital and that distortion needs to stop. There are bubbles lurking in financial markets and the zero rate policy has been the key driver. The zero rate policy has caused the reach for yield by investors which means more risk-taking than is appropriate for the economy. It does not matter whether there is limited inflation. It does not matter whether trend growth is lower than the pre-crisis levels. The seeds of another crisis are brewing, so rates should be raised now.
In the fragile economy view, the Fed should hold rates low because the economy is still fragile and the Fed should not take the downside risk of raising rates too soon. Rates have to stay low to get the economy out of the current secular stagnation. There is no bubble or financial crisis because the economy is not overheating and inflation is well below the target rate. There may be a distortion but that should lead to more risk-taking and reduce the demand for money.
It is a battle between a real economy view and a financial economy view. The misallocation or financial risk story can point to further increases in leverage outside the consumer. Misallocation view is an argument based on the potential for a crisis. The real economy, secular stagnation, view is based on output gaps and potential GDP. It is a story of economic potential. As long as these world views are so different, it is unlikely we can get agreement on what should be the right Fed policy.
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