Larry Summers: The Fed’s Good Luck Is Likely To Run Out

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From a longer piece by Larry Summers for FT

With the term of Janet Yellen as Federal Reserve chair ending next February, the president will have to nominate and the Senate will have to confirm a new head of the central bank in coming months. There is much discussion of the merits and implications of possible candidates for the job. For Donald Trump and the Senate it will be important to begin by considering the challenges that will face Ms Yellen’s ­successor.

I would have preferred a slower pace in raising rates at a number of junctures. I also think that in its statements the Fed has consistently over-assessed future inflation, growth and monetary tightening at some cost to its credibility. Overall though, it has done very well in recent years. We have not enjoyed so favourable a combination of unemployment and inflation in decades. Markets and finance have been remarkably stable, perhaps too much so, for years now. And by the standards of other institutions in Washington and central banks the Fed is highly respected. This is all a tribute to its leadership but also to fortunate ­circumstances.

I suspect the Fed’s job will be much more difficult over the next few years. Economics, finance and politics will all throw up new challenges that will probably demand creative and unorthodox responses.

If history is any guide, it is more likely than not that the economy will go into recession during the next Fed chair’s four-year term. Recovery is now in its ninth year with relatively slow underlying growth for demographic and technological reasons, very low unemployment and high asset prices. Even without these factors, experience teaches that recessions are almost never forecast or even rapidly recognised by the Fed or the professional consensus forecast, but there is at least a 20 per cent or so chance that if the economy is not in recession, it will be so within a year. So the likelihood that the next Fed chair will have to address a recession is probably about two-thirds.

Historically, the Fed has responded to recession by cutting rates substantially, with the benchmark funds rate falling by 400 basis points or more in the context of downturns over the past two generations. However, it is very unlikely that there will be room for this kind of rate cutting when the next recession comes given market forecasts. So the central bank will have to improvise with a combination of rhetoric and direct market intervention to influence longer-term rates. That will be tricky given that 10-year Treasuries currently yield below 2.20 per cent and this would decline precipitously with a recession and any move to cut Fed funds.

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There has not been a major bout of financial instability or a foreign financial crisis in the past four years. Such good fortune is unlikely to continue. There are real risks – from China to signs of overvaluation in parts of US equity markets, from build-ups in leverage after a long period of low rates and tranquil markets to a highly disordered geopolitical situation in which US credibility has fallen off sharply.

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Perhaps the most profound challenges ahead will be political. There must be more risk now of presidential interference with the Fed than at any time since Richard Nixon.

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We all have a great stake in the president making and the Senate confirming the right choice.