Chicago Booth Review Podcast Why a Soft Landing Is So Hard

Hal Weitzman: Imagine trying to land a jet on the deck of an aircraft carrier in the middle of a raging storm. That’s how Chicago Booth’s Raghuram Rajan describes the main task this year for the US Federal Reserve as it attempts a soft landing for the US economy. Welcome to the Chicago Booth Review Podcast, where we bring you groundbreaking academic research in a clear and straightforward way. I’m Hal Weitzman. Rajan was the governor of the Reserve Bank of India from 2013 to 2016, and this is the second of our two conversations with him about his recent book, Monetary Policy and its Unintended Consequences. Last time we talked about the Fed’s response to the COVID Pandemic. This time, why are soft landings so hard? Raghuram Rajan, welcome back to the Chicago Booth Review Podcast.

Raghuram G. Rajan: Thanks for having me.

Hal Weitzman: Now, this is the second part of the conversation I wanted to have with you about your book Monetary Policy and its Unintended Consequences. Last time we talked about inflation and particularly the Fed’s role in, you didn’t want to say causing inflation, because we blame the Peloton people for that, if you remember. The Peloton owners, not the company, but we did say that the Fed played a role in aggravating, let’s put it that way, inflation. You’ve recommended that central banks revert to being what they were, boring, conservative, perhaps out of the limelight. What would that mean in practice?

Raghuram G. Rajan: I think it means not being extremely aggressive for a long period of time. Okay, what do I mean by that? I mean, look, central banks have to intervene every once in a while. Certainly with financial sector problems, they have to come in and try and help resolve them. The problems I think start emerging again, if the central bank stays with accommodative policies for a really long period of time. That makes market participants, banks, borrowers, feel a little complacent and things are going to remain this way for a long period of time. They take on more risk than they should. They borrow more than they should, and when things change as they inevitably do, they’re caught out. They’re surprised.

And some of that comes from a central bank, which assures people, “Oh, we’re going to stay the course for a really, really long time,” what is sometimes called forward guidance. But it’s really this notion that the central bank works best by signaling stances for really substantial periods. And I think that’s a mistake. Anesthetizing the bond market that we talked about before, or more generally, anesthetizing market participants and telling them there’s little risk has this danger, which is they actually do take that risk and then they’re unprepared when you change the terms on them.

And I think that central banks have to always be prepared that their view of the future doesn’t turn out to be what it is, and they do have to change the terms of the bargain. I mean, you can see that with this whole inflation episode, after having sort of experienced close on one and a half decades of low inflation, suddenly everything came together and precipitated a huge inflation. And suddenly the central bank, which has been saying, “Look, this is all transitory, it’ll go away, don’t worry, be happy,” had to act and act in a way that raised interest rates faster than in many other cases before in its recorded history.

And so that is what you don’t want to do, and a better way of doing it is to always keep the market a little guessing, keep players a little guessing. Maybe you’re not as effective in making them take risks, but you also have less to deal with. And often the risks they take are not the risks you want them to take, which is build more factories, employ more people. It could be financial risks, big bets.

Hal Weitzman: But what you’re actually saying is that it’s not just that the central bank needs to be more boring and conservative, it’s the economy needs to be more boring and conservative because when it’s too exciting, things heat up too fast.

Raghuram G. Rajan: Some of that, but only to the extent... I don’t want to quell innovation. If people have great thoughts and they’re feeding on each other and they’re creating fantastic new products, so be it. But it shouldn’t be on the basis of easy money. It should be on the basis of strong value in what they’re doing. And that’s a difference. Easy money tends to essentially say, “Oh, we’re going to pump up whatever you do,” even if it’s not particularly exciting and we’re going to pay top money for some of these things. And you get a whole lot of humdrum innovation and that shows up eventually in the markets readjusting sometimes in a crisis. But if what’s happening is really interesting pathbreaking stuff, I don’t mean to dampen on that, I just mean it shouldn’t be fueled by easy money.

Hal Weitzman: Now, you are in touch with a lot of people at the Fed, I’m sure. One of your colleagues, Austan Goolsbee is on the board, but have they learned their lesson? I mean, what lessons have they drawn from the episode inflation?

Raghuram G. Rajan: I think most Fed people would say that they made a mistake in saying it was transitory. Could they have done better? Hard to say from their perspective because they would say, “Look, a lot of stuff was going on,” which is true, and it was easy to make mistakes when you’re in a new world. I mean, we haven’t had a pandemic for 100 years and of course we don’t have the modern era the last time we had the pandemic. So there is a lot of difference and I’m fully sympathetic to that, which is why mine is not saying that they should have been brainier or have more foresight, but saying maybe the right answer is, be less aggressive in every direction.

Hal Weitzman: Okay. We’re now in a period when inflation seems to be coming down. How do you think it’s going to play out in terms of central banking?

Raghuram G. Rajan: I think there’s going to be tremendous pressure on the central banks to cut rates quickly. Partly this is also energized by market participants that are trying to be the first that’s off to the races. They have a real fear of missing out if there’s a market rally, and in a sense, they won the market rally now so that they don’t have to wait. And so you already hear a lot of talk about, oh, don’t precipitate a recession, cut at the first sign that inflation is within your target. Of course, we have this real problem, certainly in the US, but also in Europe, that labor markets aren’t showing much sign of slack. They’re very tight. Anybody who wants a job typically has a job and therefore, the central bank’s real fear is yes, inflation might come down, but it may go up again unless we have some slack in the labor market.

We have to assure ourselves that this is going to stay sort of reasonable going forward. The problem of course, if they give into the markets, give into the popular view, especially given that it’s an election year in the US, if they give into the popular view that oh, make people feel a little happier, is that the markets start celebrating, people broadly feel wealthier now that the Fed has stopped its rate increases and is likely to cut or may even have cut, and you go back to spending and inflation. And so the Fed-

Hal Weitzman: And is that such a disaster?

Raghuram G. Rajan: Yes, because the Fed would have to start again.

Hal Weitzman: So once it’s going in one direction, it has to continue going in the same direction for-

Raghuram G. Rajan: Well, ideally what it would like is it to taper, that’s the soft landing, right? You use gently land and you stay landed. You don’t take off again. The problem is as soon as they say, we have landed, you’ve set all the conditions.

Hal Weitzman: It’s like on the plane, Raghuram, everyone jumps out of their seats immediately.

Raghuram G. Rajan: Exactly.

Hal Weitzman: Everybody jumps out.

Raghuram G. Rajan: Exactly, everyone jumps.... well, it’s not so much jump out as the plane starts taking off again.

Hal Weitzman: Jump onto the next flight.

Raghuram G. Rajan: Yeah, whatever. It is complicated, but as you can see, it creates problems.

Hal Weitzman: And what’s your expectation then that will they listen to that pressure? Will they stand up to it?

Raghuram G. Rajan: Chairman Powell made the... I think he keeps talking about the difference between Paul Volcker and Arthur Burns. Burns was the guy who precipitated the great inflation. Paul Volcker was the guy who killed it. And to some extent you can see who Chairman Powell sympathizes with. It’s Paul Volcker and Paul Volcker created two recessions. So from a central banker’s perspective, having slower growth, even if it means a recession, in return for creating reasonable conditions for the next two or three decades is far preferable to having the volatile inflation that Arthur Burns generated during the 1970s. That to my mind is how I would read Chairman Powell.

Hal Weitzman: Does that make the soft landing less likely then?

Raghuram G. Rajan: I think the soft landing is hard. It’s hard to generate a soft landing, right? I mean, the analogy I offer is often, look, you’re trying to land a plane on an aircraft carrier in the middle of choppy seas. There’s really a very narrow sort of deck and not much of it. And I mean the analogies go only so far. It’s tough. And I think that part of the reason it’s tough is financial markets today are so much less cooperative with the Fed. They’re just pushing the Fed, are you done yet? Are you done yet? Are you done yet? And the Fed obviously knows as soon as it says it’s done, everything is done becomes undone.

Hal Weitzman: You talked about what motivates him as an economist, but what about the reputation of the Fed, which has been somewhat sullied, hasn’t it?

Raghuram G. Rajan: If it was clear that the Fed created a recession without a reason, its reputation would be in the dog house. If there is a sense that there was high inflation and the Fed had to do what it had to do to bring it down, and yeah, we had a mild recession in order to do that, it may still be okay. I mean, remember Paul Volcker created a pretty severe recession in order to... but that was after the US had high inflation for a whole decade, and that had to be rung out. Maybe Powell can do this with a mild recession, but if that’s the price it takes, they may forgive him. Now, I’m not sure if it’s the Democrats versus the Republicans, and we have an election which swings one way or the other, whether they would be as forgiving. But nevertheless, I think the people, in hindsight, will appreciate that he did his job.

Hal Weitzman: It seems to me that central banks are somewhat stuck ‘cause they rarely get credit. If there is a soft landing, will they get the credit that they may deserve for that?

Raghuram G. Rajan: They might. I mean, as I said, it’s such a... it’s not easy to see what they’re doing and whether they’re doing it deftly or not. Everybody hangs onto their words because they want to know which way interest rates are going, but have they done their job in the most effective way possible trading off growth versus inflation? It’s very hard to decide that. And my sense is it’s not the central bank that’ll get credit if we do get a soft landing. It’s the politicians.

Hal Weitzman: Right. Talk about, I mean, you were obviously Governor of the Indian Central Bank. Talk about the rest of the world and how they’re looking at this and watching what the Fed is doing. You’ve written a lot in the past about international spillovers from US policy.

Raghuram G. Rajan: It is interesting because a bunch of central banks this time around moved ahead of the industrial countries central banks, Brazil, Mexico to some extent India, but present Mexico are the poster children for central banks having learned the consequences of past crises, and regardless of the political establishment in their country, moving to head off both inflation as well as currency depreciation and saying, “When the Western countries start raising interest rates, we should be prepared. Otherwise, we’ll have a serious outflow of capital and a taper tantrum just like we had in 2013.” Interestingly, they’ve done reasonably well. Inflation is down in Brazil and it’s been cutting interest rates. Inflation is down in Mexico, still not done serious interest rate cuts, but that might well happen. Part of the reason they haven’t is they’ve got a pretty strong economy also.

Hal Weitzman: We started by talking about how central banks should be boring, should be conservative. How do we get back to boring given where we are? Does that mean higher interest rates for longer? Is that where we settle?

Raghuram G. Rajan: No, I don’t necessarily mean higher interest rates. We have normal interest rates and don’t try to do anything for too long.

Hal Weitzman: And don’t give any forward guidance?

Raghuram G. Rajan: Try to... I mean, your forward guidance is not particularly insightful and may imprison you more it than it conveys information. The other big thing I think is, we will realize with the benefit of history, that the period of low inflation was not so bad. We didn’t have galloping deflation. We had 1-1.5% inflation. And we got into a tizzy about that. “This is too low. We are underperforming our inflation target. We have to do far more.” And we brought about this great inflation that we are seeing. And I think when we look back at those times and say, “Were we excessively worried,” almost surely the answer will be, “yes.” Now, is it possible that if we were complacent about it, we would’ve got galloping deflation? Perhaps. But I think we haven’t seen galloping deflation anywhere in the world. So in that sense, I would say that maybe one of the lessons from this whole period will be, don’t fret too much about low, but stable, inflation, worry more about being prepared for high inflation when you see the signs and act fast against it.

Hal Weitzman: And so how long do you think till we get back to low stable inflation?

Raghuram G. Rajan: Well, it depends, of course, on what the central banks do, but I would say that unless something extraordinary happens, ‘24 and ‘25 sometime is when we should be back within our inflation target if ll goes well.

Hal Weitzman: Okay, excellent. Well, we’ll have you back to check in on how that’s going later on in the year. Raghuram Rajan, thank you very much for joining us on the Chicago Booth Review Podcast.

Raghuram G. Rajan: Thanks for having me.

Hal Weitzman: That’s it for this episode of the Chicago Booth Review Podcast, which was produced by Josh Stunkel. You can find an excerpt from Raghuram Rajan’s book Monetary Policy and Its Unintended Consequences on our website, chicagobooth.edu/review, under the title, “The Case for and Against Central Bankers.” If you enjoyed this episode, please subscribe and please do leave us a five-star review. I’m Hal Weitzman. Until next time, thanks for listening. Goodbye.