Former Richmond Fed Pres. Lacker: The Fed should provide guidance that's more 'two-sided'

Key Concepts

• FOMC: Federal Open Market Committee, the body within the Federal Reserve System that sets monetary policy.
• Disinflation: A decrease in the rate of inflation.
• Accommodative Policy: Monetary policy that aims to stimulate economic activity, typically through lower interest rates.
• Restrictive Policy: Monetary policy that aims to slow down economic activity, typically through higher interest rates.
• Real Interest Rates: Nominal interest rates adjusted for inflation.
• Productivity Surge: A significant increase in the efficiency of production.
• Potential Growth: The rate at which an economy can grow without causing inflation.
• Transmission Mechanism: The process by which monetary policy changes affect the economy.
• Labor Market Friction: Impediments that prevent the labor market from reaching full efficiency.

The Federal Reserve’s Rate Path: A Discussion with Jeffrey Lacker

This discussion with former Richmond Fed President Jeffrey Lacker centers on the appropriate path for the Federal Reserve’s monetary policy, particularly in light of recent economic data and arguments from the Biden Administration. Lacker argues the FOMC has been overly optimistic about disinflation and has adopted a policy stance that is more accommodative than it realizes.

The Administration’s “Hot Economy” Argument & Productivity

The conversation begins with a critique of the Biden Administration’s tendency to describe the economy as “hot” when seeking interest rate cuts. Lacker points out the logical inconsistency: cutting rates when the economy is overheating. He acknowledges the Administration’s argument that some of the perceived “hotness” stems from a productivity surge. However, Lacker counters that a sustained productivity increase will lead to increased spending and demand, ultimately putting upward pressure on economic resources. To counteract this, he advocates for raising real interest rates to discourage immediate spending and bring demand into balance with current supply. He states, “If you expect [the productivity surge] to continue for several quarters or years, you’re going to find people wanting to bring forward those future income gains and spend them today. And that’s going to put pressure on economic resources today.”

Addressing Counterarguments Regarding Inflation

Lacker directly addresses two arguments used to justify a more dovish monetary policy. The first, presented by the Administration and some Fed members, posits that current inflation is a temporary result of tariffs and that the Fed should “look through” this temporary surge. Lacker dismisses this as “cherry picking” inflation numbers, arguing that spending displaced by tariffs will simply manifest in higher prices elsewhere in the economy. He emphasizes, “You’ve got a certain number of dollars being spent. And if tariffs weren’t so high…you’d have that spending show up somewhere else and it would drive up some other prices somewhere else in the economy.”

The second argument, put forth by Fed Governor Chris Waller, suggests that a weak labor market prevents inflation from taking hold. Lacker refutes this, stating that even with slow employment growth, increased demand for labor will still exert upward pressure on costs. He draws on the lessons of the 1970s, noting that inflationary pressures can arise even with unemployment rates of 8 or 9%. He explains that labor markets are subject to “frictions” and that the level of unemployment doesn’t guarantee protection against inflation when spending exceeds the economy’s capacity. He asserts, “The level of the unemployment rate doesn’t provide an insurance against against inflationary pressures moving if dollar spending exceeds the capacity of the economy to supply it.”

Policy Recommendations & Current Stance

Despite recent rate cuts providing some market assurance, Lacker believes current policy is not restrictive enough and leans towards being accommodative. He doesn’t advocate for immediate rate hikes but urges the FOMC to provide more “two-sided” guidance, preparing markets for the possibility of rate increases if inflation doesn’t subside. He states, “I think they ought to be providing guidance that’s more two sided, more balanced about the year ahead…They are going to be inclined to look at interest rate increases, because I think the evidence is that [the] policy isn’t restrictive at all right now.”

Growth vs. Potential Growth

The discussion then turns to how the Federal Reserve considers economic growth in its policy decisions. Lacker clarifies that the Fed focuses on growth relative to potential growth, a benchmark representing the economy’s sustainable capacity. He explains that “potential” isn’t a static concept but is influenced by economic shocks and historical context. He emphasizes that the Fed aims to maintain stable inflation even as growth fluctuates, necessitating adjustments to interest rates. He concludes, “The Fed could achieve a perfectly stable inflation rate and still have to raise interest rates up and down as growth fluctuates in order to stay on [course].”

Conclusion

Jeffrey Lacker presents a hawkish perspective, arguing that the Federal Reserve has underestimated inflationary pressures and adopted a policy that is too accommodating. He challenges prevailing arguments for rate cuts, emphasizing the importance of considering the long-term effects of productivity gains and the potential for inflation even in a seemingly weak labor market. His recommendations center on providing more balanced guidance and remaining prepared to raise interest rates if inflation persists or accelerates. The core takeaway is a cautious approach to monetary policy, prioritizing price stability over short-term economic stimulus.