WASHINGTON -- As the U.S. economy rebounds from the pandemic and inflation risks emerge, when and how will the Federal Reserve raise interest rates? Nikkei asked two former vice chairs, Alan Blinder and Donald Kohn.
Blinder said the outlook for the U.S. economy is strong and called on the Fed to immediately start tapering.
Kohn said that the Fed's outcome-based approach to making policy changes could leave them behind the curve.
Edited excerpts of the interview follow.
Alan Blinder says the outlook for the U.S. economy is strong. Alan Blinder, Gordon S. Rentschler Memorial Professor of Economics and Public Affairs at Princeton University and former vice chair of the Fed under President Bill Clinton
Q: You have talked about an interest rate hike as early as 2022. What is your view on the state of the economy and your outlook for a rate increase?
A: Those two are very, very related. My outlook is for extremely strong growth in the near term and carrying over, though not quite as strong, into 2022. We may have in the quarter that just ended 7%, 8% or maybe 9% annualized growth. It will be a very big number.
That's not going to keep up. But I think there's enough momentum and enough fundamentals pushing forward that 2022 is going to be another above-trend growth year. So, if we have any slack left at the end of 2021, it will get dissipated in 2022, and it's still possible that we don't have slack left at the end of this year, and in 2022 we'll start going above full employment.
There's plenty of uncertainty around that. But the outlook is strong. For that reason, the Fed's last published forecast, which implies a very rapid, more or less immediate, decline in inflation -- I don't really think that'll happen.
First of all, inflation in the first half is higher than the Fed thought it would be. It's higher than almost anybody thought it would be.
Secondly, I think inflation in the second half of the year is going to be higher than the Fed's forecast. So the view that the Fed was not going to touch interest rates until 2024 or maybe 2023, I think, is starting to fade.
Q: The Fed thinks the inflation is a transitory phenomenon. But the question is how long?
A: I very much think it's transitory. I'm 100% with them on that. But "transitory" doesn't mean it only lasts a month or two. We're not over the bottlenecks. We have a surge of pent-up demand from consumers coming. Transitory could mean five, six, eight months rather than one or two months, and if that happens, then prices of one thing get into prices of other things. Wages are accelerating, as you know. I'm not horribly worried about that, but it's on the list of reasons to be a little bit concerned about inflation perking up.
We're going to have above 2% inflation for a while, I believe. The Fed's forecast has 2022 inflation at 2.1%. I think it'll be higher.
Q: Prior to the interest rate hikes, when and how will we see tapering of asset purchases?
A: My opinion would be to start tapering right away. Remember, tapering just means reducing the amount that you're buying. It's easing off on the accelerator, not stepping on the brake.
They're not going to do it now. They're going to take their time. They're consensus driven. I think they are more sanguine about inflation than I am. So, I don't think that's what the Fed will do, but I think they should get started relatively soon. Probably they won't get started until very late this year.
When the time comes to taper, they will taper Treasurys and mortgage-backed securities in the same proportion that they're buying.
I think what they should do is taper the MBS much faster. The mortgage market is not a problem. This is not 2009. When the Fed started buying MBS in 2009, there was a really good reason to do it. Part of that reason was that the mortgage market was dead, completely dead.
It's the opposite now. If anything, we're in a housing bubble. Housing is in great demand, and prices are going up fast. To me, that's not a time that mortgages need special help from the central bank.
Q: Before the pandemic, low inflation was a conundrum for the economy. Has the pandemic changed the dynamic of inflation?
A: We don't know yet. The pandemic has thrown monkey wrenches everywhere, upset every kind of normal relationship you can think of, and basically thrown a thick fog around the data. Last Christmas and then after were not the normal Christmas season, but the data gets seasonally adjusted for a normal Christmas season. There are always seasonal adjustment issues having to do with the school year, employment in May-June, and then coming back in September.
Q: The Fed says any policy change will be outcome-based. Is there a risk of them being behind the curve?
A: The Fed's new strategy -- recognizing that inflation until recent months just wouldn't budge in the upward direction, and so they would wait to see inflation go up before they'd take any action -- implies almost mathematically that they'll be behind the curve when the time comes, that they're not going to move until inflation is above 2%.
It's basically a tautology. They'll be really behind the curve.
Q: What is the biggest risk in the current financial market?
A: I would have given you the same answer a year ago: rising long-term interest rates. Now, worrying about that a year ago turned out to be very wrong. But I still look at the level of long-term rates.
I don't think this is going to be a gigantic crash, like the long rate is going to 5% or anything like that. But if the long rate would go from 1.6% to 2.6%, that's a big deal.
Donald Kohn says Americans have extra savings that they are going to be able to use to consume. Donald Kohn, Robert V. Roosa Chair in International Economics at the Brookings Institution and former vice chair of the Fed under President George W. Bush and President Barack Obama.
Q: What is your view on the U.S. economy?
A: The outlook for the U.S. economy is very good. We have the recovery from the pandemic and people are getting more comfortable going outside, going to shop and travel, restrictions are being lifted. In addition, we have, still, very expansionary fiscal and monetary policies in place and a lot of excess savings of people who got support through fiscal policy or continued to work through the pandemic and couldn't spend, so they have extra savings that they're going to be able to use to consume.
Q: Many people are anxious about inflation risk. How do you see that?
A: Inflation will not continue at the extremely rapid rate that it's been over the last three or six months. But the Fed itself wants inflation in 2022-2023 to be a little over 2%. I think we'll get that and the risk is they could get more than they're looking for.
Q: The Fed has said the acceleration in inflation is transitory.
A: I agree with the Fed that a very high proportion of what we're seeing now is transitory, as a result of chip shortages for automobiles and supply chain disruptions. But we have some other factors that maybe aren't so transitory. You have the rising price of houses, which will eventually get built into rents, and those will show up in inflation figures too.
Whether it goes back all the way to the 2% or the 2.1% that the Fed is predicting, that's the open question.
Q: When is the timing of the next interest rate hike?
A: I was not surprised by the 2023 liftoff in the so-called dot plot. If anything, I was surprised, in March, that they didn't have a liftoff in 2023. The basic idea that 2023 will be time to start raising rates is a very reasonable expectation. I'd be a little surprised at 2022. I do think it depends a lot on what happens to these inflation numbers and the wage numbers.
Q: When and how should the Fed begin tapering of asset purchases?
A: What the Fed have said is that they want to see substantial further progress, both on inflation and in the job market. They've already seen what they need on inflation. The job market is hard. It's hard to define what you mean when it's supply holding you back, not demand.
So I think they'll wait at least until the fall to make a judgment on that. By the fall -- September, October, November -- they'll be able to see whether their expectation that more people will join the labor force, that the upward pressure on wages and prices will be alleviated, they'll see whether that's true or not, and if it's not true they'll have to start tapering sooner rather than later.
But I think their own expectation is consistent with tapering around the end of the year, the beginning of next year.
Q: The Fed is focused on an outcome-based policy change. Some people say that could put the Fed behind the curve. What do you say?
A: There is a definite risk that unless things change, as they go through this period, that they could be behind the curve, that they could overshoot even their average inflation target. They've said in their announcement they want to be accommodative until they meet their goals. If there are any lags in the effects of monetary policy, they will overshoot even their average goal. And they haven't even defined what the goal is.
Q: After the pandemic, a group of people have exited the labor market through early retirement. Will the labor participation rate recover?
A: After a while, and they feel safe getting back into the labor market, and if there are a lot of jobs and the wages continue to rise rapidly, you could bring some of them back into the labor force.
People who expect to live longer will need more savings to live on. Early retirement is not a new trend. I don't see that continuing.
Q: GDP growth in 2022 will be lower than this year. Is there a risk of the economy significantly slowing down?
A: No. Even at 2% or 3% growth, we'll be at what will be good increases in production and in employment. As long as the unemployment rate remains low, employment high, there are lots of jobs, I think slowing down will be good. It would make it a more sustainable situation.