Monetary Policy Overshooting A Recession?

Tim Duy wrote a post yesterday called, Heading into Jackson Hole. He gives a broad perspective of the economy relevant to monetary policy, which of course will be the major topic of discussion in Jackson Hole.

He recognizes that wages need to rise even though firms complain of not being able to fill job openings.

“Anecdotally, firms are squealing that they can’t find qualified workers.  Empirically, though, they aren’t willing to raise wages.”

Then he talks about the Fed wanting to fight inflation instead of an economic downturn. In other words, the Fed would rather keep monetary policy loose to support economic growth and risk inflation, instead of tightening too early and creating an economic downturn.

He cites an article from Reuters, Yellen resolved to avoid raising rates too soon, fearing downturn, by Howard Schneider and Jonathan Spicer.

“…The nightmare scenario she wants to avoid is hiking rates only to see financial markets and the economy take such a hit that she has to backtrack. Until the Fed has gotten rates up from the current level near zero to more normal levels, it would have little room to respond if the economy threatened to head into another recession.”

His view is that the Fed should overshoot inflation to the 2.25% – 2.5% range. But my view is that the economy will not be able to make it back up to 2.5% inflation before the next recession due to the following reasons…

• As the Fed continues to project lower nominal rates in order to overshoot the inflation target, inflation will stay muted due to the Fisher Effect. (I have written about this before.)
• The effective demand limit is biting in Europe and will soon bite in the US. The economy will peak out in spite of the Fed keeping nominal rates low. Therefore the Fed will most likely be caught with an effective zero-lower-bound rate going into the next recession.
• Inflation will be subdued as consumption will under-perform because capital income is dropping its consumption as asset prices stall.
• China will want offload its massive production at lower prices. We see investment and lending highly reduced recently there. (link) China is up against its own effective demand limit. It will try to suck what it can from the US market at competitive prices.
• Wage growth will stay mild in the US, even as hiring increases. Unemployment is still relatively high. Price hedging is muted, which will mute wage offers. Mr. Duy recognizes the price trap upon wage growth.