Is Monetary Policy Really Too Loose?

There has been a lot of discussion recently on the stance of monetary policy. As noted over at Macroblog, many observers believe that monetary policy has been too loose as evidenced by the negative real (or inflation-expectations adjusted) federal funds rate. These observers are concerned that a negative real policy rate may cause, all else equal, inflationary expectations to become unanchored and lead to a repeat of the 1970s-like inflationary spiral. Some observers argue, though, that all else is not equal and that negative real interest rates do not necessarily imply these outcomes. Rather, one must look at real fed funds rate relative to its neutral rate value. Paul McCulley of PIMCO puts it this way:

All sensible discussion of the “right” real Fed funds rate logically must begin with the proposition that the putative “neutral” equilibrium real Fed funds rate is not constant, but rather time varying, a function of financial conditions, notably whether levered financial intermediaries – conventional banks, as well as shadow banks, a term I coined last year at Jackson Hole – are ramping up or ramping down their leverage. The former will lift the “neutral” real rate while the latter will reduce it. Thus, a high Fed funds rate may not be restrictive at all while a low Fed funds rate might not be stimulative at all.

I too agree one should look at the neutral rate value when assessing what the fed funds rate tells us about the stance of monetary policy. However, I would go beyond just financial conditions as suggested by McCulley and also consider productivity growth, intertemporal preferences, and population growth--the determinants of the natural interest rate in a standard growth model-- in assessing the neutral interest rate. Doing so, however, is non-trivial task and many sophisticated econometric attempts have been made with mixed results to estimate the neutral rate.

One easy way to get a sense of whether the fed funds rate is near its neutral rate is to use what I call the policy rate gap measure: the difference between the year-on-year nominal growth rate of the economy and the federal funds rate. This measure, popular with The Economist magazine and some industry economists, shows monetary policy to be too loose when the federal funds rate is significantly below the economy's nominal growth rate and too tight when it is significantly above it. According to Brian Wesbury, the federal funds rate should be within 1% of the economy's nominal growth rate to be neutral. This measure is convenient because it provides an approximation to a neutral fed funds rate without having to resort to real values. [Both measures are in nominal terms so the inflation component drops out in the differencing.]

I have been highly interested in this measure and have shown previously that it does a good job predicting recessions. One issue that has recently come to my attention, though, is how to best measure the economy's nominal growth rate. Previously, I used nominal GDP in constructing this measure. However, some commentators have pointed to Gross Domestic Income as a better measure of current economic activity. Jeremy Nalewaik, in particular, has shown that “real-time GDI has done a substantially better job recognizing the start of the last several recessions than has real-time GDP.” With these findings in mind I constructed the policy rate gap measure with both GDP and GDI to get a sense of the stance of monetary policy today. Here is what I got (click on to enlarge):


These figure indicates that if GDI is used, monetary policy is indeed neutral as suggested by Paul McCulley. If, however, GDP is used then there is a stronger case that monetary policy has been loose. Currently I am inclined to cast my lot with GDI--the bad economic news today seems to confirm my prior--and conclude monetary policy is more or less neutral. For good measure, I also made note in the graph of the massive Greenspan monetary easing of 2003-2005.

Update: Although it may be clear to some readers, the above post does not explain why the policy rate gap can be considered a measure of the stance of monetary policy. To correct this omission, I turn to The Economist magazine who says the the way to “interpret this [measure] is to see America’s nominal GDP growth as a proxy for the average return on American Inc. If the return is higher than the cost of borrowing[i.e. the interest rate], investment and growth will expand [and vice versa]. Alternatively, one could argue if the real economy is growing faster as the result of productivity gains or population growth (via increased labor supply, which in turn implies a higher marginal product of capital, ceteris paribus) and assuming intertemporal preferences are relatively stable, then the real interest rate should be higher too. Throw in the nominal component to the measures of the real economy and real interest rate and one should see similar movements and/or convergence in the nominal growth rate of the economy and the federal funds rate. If these patterns are absent, then one can argue that monetary policy is causing the real rate to deviate from the rate implied by the fundamentals.

Empirical Evidence on the Fed as a Monetary Hegemon

I recently made the following claim:

[The] Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar.

I suspect the most contentious part of this claim is the part where I said the ECB has to be mindful of the Fed's actions. I made a case for this view based on a figure that showed the path of the policy rates for the Fed and the ECB. Fortunately, I can now point you to more rigorous empirical work by John Taylor that supports my position:

...Many central bankers, even those with flexible exchange rate policies, watch the U.S. federal funds rate carefully when making policy decisions.

To illustrate this issue consider the relationship between Eurozone interest rates and U.S. interest rates during the past few years. Consider in particular the deviation of the overnight interest rate target for the European Central Bank from a simple guideline for that interest rate—the Taylor rule...

Now if one examines the relationship between this deviation and the actual federal funds rate in the United States during the period from 2000 through 2006, one finds a close empirical correlation between the two. An estimated linear relationship with the deviation on the left hand side has a coefficient on the federal funds rate of 0.21, which means that each percentage point reduction in the federal funds rate was associated with a 1/5 percentage point reduction in the ECB interest rate below what would otherwise be desirable on European price stability and output stability grounds... The relationship is highly significant statistically... For part of this period the ECB policy rate was below this guideline and according to these estimates a significant part of the deviation is “explained” by the U.S. federal funds rate being lower than normal.

You can read the rest here.

A Misguided Greenspan Defender

Alan Greenspan has been busy lately defending his legacy. He is responding to the ground swell of opinion that views him as a key contributor to the U.S. housing boom-bust cycle. Fortunately for him, he has one prominent observer coming to his defense: Martin Wolf of the Financial Times. Here is what Martin has to say:

When a wave of destruction hits, everybody looks for somebody to blame. Alan Greenspan, former chairman of the US Federal Reserve, once lauded as the “maestro”, has, to his discomfort, become the scapegoat... much of the criticism is highly unfair.

[...]

US monetary policy cannot be responsible for all these bubbles. This might not be the case if these other countries had followed US policy slavishly...

Really? What do we know about the ECB? Did it follow the Fed's lead in cutting rates? Here is a graph from the IMF's latest WEO report that sheds some light on this question:


It sure looks to me like the ECB followed the Fed's lead in cutting short-term interest rates. If we look at real short-term interest rates the picture is even more stark:

Both the Fed and the ECB pushed short-term real interest rates into negative territory for a sustained period. Negative real interest rates in a growing economy are a sure way to light an asset bubble fire. Now take a look at the following graph. It indicates these downward interest rate moves were policy-driven:
This figure shows a large spike in the policy-determined monetary base relative to the G3's GDP. In sum, these figures indicate loose monetary policy in the U.S. and the ECB coincided with the global housing bubble.

An important question these figures do not answer is why would the ECB (and other monetary authorities) follow the Fed's lead in loosening monetary policy? The answer is that the Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. The Fed's loosening, therefore, of monetary policy in the early-to-mid 2000s triggered a global liquidity glut that set the stage for the subsequent housing boom-bust cycle. This is not to say the 'saving glut' and financial innovation had no role, but rather that loose monetary policy was a key factor behind the boom.

William Buiter writing at Financial Times does a nice view articulating this view in his article titled "The Greenspan Fed: A Tragedy of Errors":

Mr Greenspan is correct that a major global decline in risk-free real interest rates was an important factor in the housing booms that occurred in a couple of dozen countries between, say, 2002 and the end of 2006[.]

But the fact that on top of these very low risk-free long-term real rates, credit spreads became extraordinary low, had something to do with the liquidity glut created by the Fed, the Bank of Japan and, to a slightly lesser extent, the ECB. The Fed kept the Federal Funds rate target too low for too long after 2003. Because of the unique role played by the US dollar in the global financial system, the US dollar liquidity shower not only soaked the US economy, but also many others. First those who kept a formal or informal peg vis-a-vis the US dollar. Then those whose monetary authorities, without pursuing a dollar peg, kept a wary eye on the exchange rate with dollar, and ultimately most central banks in the globally integrated financial system.

Well said Dr. Buiter.

Allan Meltzer Goes for the Fed Jugular

Allan Meltzer gets shrill in this Wall Street Journal article. He argues (1) the Fed is becoming more politicized and, as result, (2) is making some decisions that will be very costly in the future. What is really causing Allan all this angst is the specter of 1970s-style stagflation. He experienced this stagflation firsthand and the subsequent 'cleansing' Paul Volker's Fed had to undertake to bring back macroeconomic order. Melzter does not want to see it happen again.

That '70s Show
Is the Federal Reserve an independent monetary authority or a handmaiden beholden to political and market players? Has it reverted to its mistaken behavior in the 1970s? Recent actions and public commitments, including Fed Chairman Ben Bernanke's testimony to Congress yesterday -- where he warned of a steeper decline and suggested that more rate cuts lie ahead -- leave little doubt on both counts

... In the 1970s and again now, Federal Reserve officials repeatedly promised themselves and each other that they would lower inflation. But as soon as the unemployment rate ticked up a bit, the promises were forgotten... People soon recognized that avoiding possible recession overwhelmed any concern about inflation. Many concluded that inflation would increase over time and that the Fed would do little more than talk. Prices and wages fell very little in recessions. The result was inflation and stagnant growth: stagflation.

... One lesson of the inflationary 1970s: A country that will not accept the possibility of a small recession will end up having a big one when the politicians at last respond to the public's complaints about inflation. Instead of paying the relatively small cost of a possible recession, the public pays the much larger cost of sustained inflation and a deeper recession. And enduring the deeper recession is the only way to convince the public that the Fed has at last decided to slow inflation.

... The freezing up of short-term financial markets called for more borrowing... But the rush to bring real short-term interest rates to negative values is an unseemly and dangerous response to pressures from Wall Street, Congress and the administration. The Federal Reserve became "independent" in 1913 so that it could resist pressures of that kind.

... The Fed's recent behavior is in sharp contrast to the European Central Bank. The ECB keeps its eye on both objectives, growth and low inflation. It doesn't shift back and forth from one to the other. The Fed should do the same.

The Next Big Bubble?

We live in interesting times. Oil and other commodity prices continue to rise even as global demand is presumably slowing down. Normally, one would expect commodity prices to slow down with a weakening global economy. What explains these developments? As The Economist notes, it cannot be supply conditions since they have not dramatically worsened recently. James Hamilton believes these developments may indicate the economy will be improving in the near future. The uptick in commodity prices is simply a reflection of their role as a leading economic indicator. Maybe he is correct, or maybe we are seeing the beginning of the next big monetary policy-generated bubble.

Jeffrey Frankel of Harvard University has shown there is an important negative relationship between real interest rates and real commodity prices, with causality running from the former to the latter. Here is one illustrative graph from his work:

One story Frankel tells is that as monetary policy lowers interest rates speculators shift out of treasury bills into commodity contracts. Hence, the recent rate cuts by the Fed are generating a movement of liquidity into commodities. This story gets even more traction when we consider that the other big asset markets--stocks and housing--that would normally attract this liquidity have already been bubbled and popped. Lquidity, then, is looking for a new home to make a bubble and commodities seem to fit the billing this time around.

While this view is only one interpretation of the recent surge in commodity prices, it strikes me as reasonable. If time shows it to be true, the Fed will have unwittingly lived up to its reputation as a serial bubble blower.

The Rise of Financial Populism

Although one can make reasonable arguments for the recent rate cuts by the Federal Reserve, there is the appearance that the Federal Reserve is simply responding to cries of help from Wall Street. Perception can often be more important than reality and if played out it can become reality. So even if the Federal Reserve was acting from an objective, fact-based perspective, its recent rate cut decisions may come to be seen as meaning the Federal Reserve has a new mandate to bail out Wall Street--it is simply too important to fail.

Some observers(here, here), however, take a even stronger position and assert that the recent rate cuts were not based on sound economic analysis, but rather on the Federal Reserve responding to panic-driven volatility in equity markets. Here, the Federal Reserve is consciously responding to the pleas of help from Wall Street. Both scenarios imply a troubling development. Robert Samuelson calls it 'financial populism' in a recent article. Some excerpts:

Jim Cramer -- the hyperactive, loud and opinionated host of CNBC's "Mad Money" -- is no fan of Federal Reserve chairman Ben Bernanke. If you'd tuned into "Mad Money" any time in recent months, you might have caught one of Cramer's outbursts against the ex-Princeton University economics professor. "Defend us from Uncle Ben Bernanke's relentless march to recession," went one rant. "You know what Bernanke is? He's the General Sherman of monetary policy. He's waging total war against the American economy."

Call this the rise of financial populism. Cramer is its biggest star and, in some ways, it has fundamentally altered the climate in which the Federal Reserve makes economic policy. Throughout its history, the Fed has rarely been popular (the peaceful period in the 1990s under Alan Greenspan was an exception). People often blame the Fed for recessions or high interest rates. But traditionally, politicians, business leaders and unions have been the most vocal critics.

No more. In recent months, the noisiest criticism of the Fed has come from Wall Street.

The rise of financial populism is certainly troubling. But if one makes the argument that the excesses from the past housing bubble and its related mess in credit markets needs to be sorted out, then financial populism becomes even more troubling since it aims to avoid the painful corrections needed. The always enertaining Daniel Gross raises this point in a recent article:

Wall Street traders are the infants and toddlers. They're the tykes who stage public tantrums, screaming and yelling and writhing on the floor until they get what they want. Since the markets began to buckle last summer, what traders want is interest-rate cuts and other government measures to bail out banks from reckless and disastrous lending and investment decisions. In response, Federal Reserve chairman Ben Bernanke has done what any exhausted parent does when a child screams for three hours straight: he gives in. In the past two weeks, the Fed cut interest rates sharply twice, taking the Federal Funds rate down from 4.25 percent to 3 percent.

Of course, "giving in to a tantruming child just reinforces the demand," says Dr. Wendy Mogel, a clinical psychologist in Los Angeles and author of the wildly popular parenting tome "The Blessing of a Skinned Knee." And each time you cave to a screaming child, it buys you less quiet. The Federal Reserve's latest attempt to calm the market's tantrums—the half-point interest-rate cut on Wednesday—bought about 90 minutes of market silence. Within hours, as poor economic news continued to materialize, the clamor for further rate cuts began to rise. Mogel puts it in starkly financial terms: "Indulge tantrums and you get short-term gains and long-term loss"...

The same might be said about Washington's current economic ministrations. The nation is now nursing a seriously skinned knee because of reckless behavior in housing and credit. But rather than force consumers, borrowers and bankers to face the consequences of their own actions, Washington is functioning as a helicopter parent. Harvard economist Ricardo Hausmann, who characterized America as "whiner of first resort," believes the rush to stimulus is being led more by a concern for Wall Street than a concern for Main Street. Rather than take their lumps after several years of exceptional returns, the banks are furiously lobbying for help. They're getting it.

The rise of financial populism suggests that Federal Reserve is becoming more politicized, even though it is designed to be independent from political pressures. Chalk one up for Jim Cramer and the other liquidity addicts of the world.

The Challenges Ahead for the Fed

This Bloomberg article highlights some of the challenges the Fed faces as it pushes real interest rates back into negative territory:

``The Fed is going to have to keep slashing rates, probably below inflation,'' said Robert Shiller, the Yale University economist who co-founded an index of house prices. ``We are starting to see a change in consumer psychology"... So-called negative real interest rates represent an emergency strategy by Chairman Ben S. Bernanke and are fraught with risks. The central bank would be skewing incentives toward spending, away from saving, typically leading to asset booms and busts that have to be dealt with later.

Negative real rates are ``a substantial danger zone to be in,'' said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed bank. ``The Fed's mistakes have been erring too much on the side of ease, creating circumstances where you had either excessive inflation, or a situation where there is an excessive boom that goes on too long.''

Read the whole thing

The Fed Apologist

One of the top monetary economists in the nation is seemingly bent on being a Fed apologist. Over at the WSJ Real Time Ecomics blog, Mark Gertler is defending the Fed's surprise interest cut last Tuesday. This is too bad, but not altogether surprising given his defense of the Fed's extremely loose monetary policy during the 2003-2005 period. Here is what he says regarding Tuesday's rate cut:

"... plans for significant easing was in the works before Tuesday. The global asset price decline certainly influenced the timing of the cuts, but I don’t believe it’s going to affect the medium term path of the Funds rate, which is going to be governed by events in the real economy."

So he admits global asset prices influenced the timing of the decision to cut rates. Does he not find this troubling? Since when is it in the Fed's mandate to respond to stock market movements? The only way to wiggle through that question is to reply (a) the stock market is harbinger of things to come in the real economy or (b) that the stock market decline itself will create real economic problems. He opts for the later:

"... [G]iven the weakened state of financial institutions, a sharp asset price contraction had the potential to significantly disrupt credit flows and thus do significant harm to the real economy. The Fed action offset this potentially disruptive chain of events."

Even if he is correct in this assessment, I see several new problems the Fed has created by this action. First, it sets a precedent for a 'Bernanke Put', similar to the 'Greenspan Put'. The market now knows that in the mind of the Fed it is too important to fail because of the potential real economic harm it may cause. Second, although Mark Gertler says the 'medium term path' of the fed funds rate has not changed because of this move I am less certain. The Fed's move last Tuesday set in play a whole new dynamic, as market expectations have now changed. How can Mark be so confident the 'medium term path' will now be the same? This is not a static world. Third, the Fed just used up a large chunk of their valuable ammunition on an uncertain outcome. Given the liquidity trap rumblings we now hear, this rate cut may be costly down the road. I may be wrong in my assessment, but for now the rate cut still appears to me as a panicked Fed responding to market volatility.

The Economist and Benign Deflation

I had the privilege today of meeting Zanny Minton Beddoes, the economics editor for The Economist magazine. She was a presenter at at a regional economic outlook conference held in nearby Austin, Texas. Her part of the program was to deliver an assessment of the national economy. She did a great job describing the major shocks that have recently hit the U.S. economy--high oil prices, frozen credit markets, housing market bust--and the potential outcomes of these shocks. After her talk, I was able to chat with her for a few minutes. Among other things, I complemented her and The Economist for taking seriously the implications of benign deflation for the U.S. economy during the 2003-2005 period. As I have argued before, the Fed's misreading of the 2003 deflationary pressures as being malign when in fact they were benign led to an overly accommodative monetary policy at that time. As a consequence, interest rates were pushed far beneath their neutral level and the stage was set for the biggest housing boom-bust cycle in U.S. history. The Economist recognized this was happening and was one of the few observers sounding the alarm over this development (Andy Xie was another, see here). Only now are other observers (here, here) beginning to see how prescient The Economist was in its calls to reign in monetary policy during this time. It was a real treat, then, for me to meet Zanny, and briefly discuss these issues with her.

In case you missed The Economist's coverage of benign deflation and its implications for the U.S. economy during the 2003-2004 period, I have posted below an edited version of an article that appeared in 2004.

Inflated expectations
Jul 1st 2004

From The Economist print edition

A new paper questions whether inflation will really turn out to be America's main economic problem... Most commentators have cheered Alan Greenspan and his colleagues at the Fed for being so aggressive in warding off the deflationary threat caused by huge corporate debts and the popping of the stockmarket bubble... Mr King is not among those cheerleaders. He argues that the Fed was wrong to cut interest rates so much, because much of the deflationary pressure was of an altogether more benign sort: a reduction in overall prices caused by rapid technological change, improvements in the terms of trade and other factors. Britain had long periods of “good” deflation in the late 18th and 19th centuries, when nominal interest rates and growth were both strong. In recent years, argues Mr King, there has again been deflation of just that sort, and for similar reasons. Technological change and the integration of China, and increasingly India, into the global economy have pushed down the price of traded goods in America, thus pushing up real incomes. “And, because of these real gains, any rise in real debt levels will not be a source of potential ongoing instability,” writes Mr King. Alas, because the Fed's perceptions of deflation have been coloured by the experiences of America in the Depression and Japan in its lost decade, it reacted by reducing interest rates sharply, a response that is more likely to bring about the debt deflation it most feared.

High real growth—so long as deflation is of the good sort—requires high real interest rates. If rates are too low, people borrow too much and spend it badly: what Mr King calls “happy investment rather than good investment”. For a given level of nominal interest rates, a fall in prices will deliver the appropriate level of real interest rates. But by cutting nominal rates to prevent deflation, the Fed has reduced the real rate of interest too much.

Evidence that this has been the case comes in two forms. The first is that borrowing has ballooned in America in recent years. Any reduction in the indebtedness of American firms (under immense pressure from the capital markets) has been more than matched by borrowing by consumers and the government...

[T]he second piece of evidence [can be seen in] what Americans spend their money on. If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years. Companies have been slow to hire workers even as the economy has bounded along; and workers' share of national income is very low. The low cost of capital has, moreover, encouraged speculation in risky assets, such as emerging markets, or—closer to home, as it were—property. And, yes, with all that money sloshing about, it has also pushed up inflation a bit...

There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think—and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid.

If you want more, see Unnaturally low.

Today's Surprise Fed Funds Rate Cut

I find today's fed funds rate cut troubling. Since when does the Fed's mandate cover activity in global stock markets? And no, I do not buy the argument that the fall in global stock markets somehow represents brand new information--that did not exist a few days ago--about the possibility of a U.S. recession. The market sell off was pure panic driven and the irregular timing of this rate cut makes the Fed look panic driven too.

I really like Ben Bernanke, but this response blows my mind away. The only reasonable justification for such action is that the Fed knows something the markets do not know. If so, then the markets have even more reason to panic and sell off.

So how does Wall Street feel about this move? CNBC did a quick survey today and found,

"Nearly 75 percent of Wall Street pros responding to the CNBC Trillion Dollar Snap Survey think the Federal Reserve did the right thing by cutting interest rates by three-quarters of a point, to 3.5%, this morning."

Surprise, surprise. Stepping away from Wall Street, where the intoxicating influence of liquidityholics like Jim Cramer is hard to avoid, one can find more thoughtful observers. For example, Willem Buiter of the London School of Economics writes in Financial Times the following:

"It is bad news when the markets panic. It is worse news when one of the world's key monetary policy making institutions panics. Today the Fed cut the target for the Federal Funds Rate by 75 basis points, from 4.25 percent to 3.50 percent. The announcement was made outside normal hours and between normal scheduled FOMC meetings.

This extraordinary action was excessive and smells of fear. It is the clearest example of monetary policy panic football I have witnessed in more than thirty years as a professional economist. Because the action is so disproportionate, it is likely to further unsettle markets. Even the symptoms of malaise that appear to have triggered the Fed's irresponsible rate cut, the collapse of stock markets in Asia and Europe and the clear message from the futures markets that the US stock markets would follow (a 500 point decline of the Dow was indicated), are unlikely to be improved by this measure and may well be adversely affected.

In the absence of any other dramatic news that the sky is falling, I can only infer from the Fed's action that one or both of the following two propositions must be true.

(1) The Fed cares intrinsically about the stock market; specifically, it will use the instruments at its disposal to limit to the best of its ability any sudden decline in the stock market.

(2) The Fed believes that the global and (anticipate) domestic decline in stock prices either will have such a strong negative impact on the real economy or provides new information about future economic weakness from other sources, that its triple mandate (maximum employment, stable prices and moderate long-term interest rates) is best served by an out-of-sequence, out-of-hours rate cut of 75 basis points.

The first proposition would mean that the Fed violates its mandate. The second is bad economics."

Another example comes from Felix Salmon:

"There's nothing in there to justify a huge rate cut in the week before a regularly-scheduled meeting. Tighter credit for some households? Come on. There's one reason and one reason only that the Fed took this move, and it's the plunge in global stock markets on Monday, along with indications that the US markets were set to follow suit.

Now the Fed is charged with keeping employment high and inflation low; it's not charged with protecting the capital of investors in the stock market. So this action smells a bit like panic to me, and it might also have prevented the kind of stomach-lurching selling which could conceivably have marked a market bottom. I have to say I don't like it."

Sigh...

Why the U.S. Needs A Recession to Correct Global Imbalances

I have argued in previous postings that past monetary policy profligacy in the United States has contributed to the global imbalances (here, here, here, and here). Here is an article by Gilles Saint‑Paul that takes a similar view and follows this line of reasoning to its logical conclusion: the current easing by the Federal Reserve puts off the correction of these imbalances--and allows them to continue to build--until a later time when correcting them will be more painful.

It is refreshing to see a thoughtful article on global imbalances that does not bow at the altar of the 'saving glut' goddess. This article takes seriously the 'liquidity glut' view of global imbalances and shows why the conduct of monetary policy for the world's reserve currency can be distortionary for the global economy.

Update: Saint-Paul mentions Volker's recessions in the early 1980s. See here for comments on this experience

Update II: Bill C at Twenty-Cent Paradigms cautions us not to put too much faith in the ability of monetary policy to correct the global imbalances.

How the US imbalances can be corrected
Gilles Saint‑Paul

There is agreement among many analysts that the Fed should pursue a low interest rates policy in order to prevent the US credit crisis from degenerating into a recession. On what grounds are we told that? The bottom line is that monetary policy is supposed to fine-tune the economy by targeting inflation and the output gap. Thus, monetary policy is supposed to become tighter when there are fears of inflation, and looser when there are fears of a recession and no sign of inflation. Consequently, the fed’s recent moves to lower interest rates seem perfectly orthodox.

This focus on macroeconomic aggregates ignores any other effect that interest rates can have on the economy. It totally ignores that interest rates are a price which affects many allocative decisions and has important distributive consequences. In 2001, the Fed engaged in a policy of drastic reduction of interest rates, for fear that the conjunction between the end of the so-called “Internet bubble” and the attacks of September 11 would drive the US economy into a recession. These considerations were compounded by the increasingly popular view that inflation was no longer a problem. The strong expansion of the late 1990s had been accompanied with little inflationary pressures and there were fears that the deflationary experience of Japan might hit the United States.

The result of these policies is that the US was in a regime of very low real interest rates. From 2002 to 2004, the federal funds rate did not exceed some 1.5 %, while inflation moved from 1.6 % to 2.7 % during that period. Thus short-term real interest rates were clearly negative. As for longer maturities, some real rates fell to 1.5 %. Many would argue that this was the right thing to do; GDP stayed at its potential level, or below it, and the incipient increase in unemployment was reversed.

The problem is that low interest rates not only stimulate the economy, they do plenty of other things. In other words, focusing only on GDP has costs and may generate mounting problems—the low rates policy makes a current recession better, but the next one may be worse.

One reason why the US economy is less inflation-prone than in the past is that a bigger share of any increase in domestic demand is absorbed by imports: the economy is more open than it used to be. Thus, instead of having “overheating” because demand is greater than supply, the gap between the two is filled by trade deficits. Hence, low rates stimulated consumer spending and the trade balance deteriorated by two percentage points of GDP. The US is rapidly accumulating foreign debt and that may lead to a brutal correction with a sharp drop in consumer spending and a large depreciation of the real exchange rate. In fact, that correction may have already begun. Yet the Fed is not supposed to look at the net foreign asset position of the US economy, even though both its deterioration and rising inflation are the symptom of the same problem – excess domestic demand.

The other issue is asset prices. When interest rates are very low, and expected to remain so, asset prices can be very high. In fact, when interest rates fall below the growth rate, assets become impossible to price. Consider, for example, a share that pays a dividend which grows at 5 % a year. With a 2% interest rate, it is profitable to buy that asset regardless of its price, because I only need to hold it for a sufficiently long time for the dividends to eventually exceed the interest payments. So the price of the asset is in principle infinite. In fact, people do not live forever, so they will have to sell the asset back at some point; but one can show that any change in markets' expectations about that future price can be validated by a corresponding change in the current price—so, the current price can be anything.

In particular, low interest rates may start asset bubbles. One mechanism is as follows. As the price starts rising due to lower interest rates, irrational speculators start buying the asset on the grounds that the price increases are going to continue. That fuels the price increase which may eventually develop into a bubble where all speculators, including the rational ones, pay a high price for the asset because they expect the price to be even higher in the future. So one by-product of the fall in interest rates is that real house prices started to go up very quickly.
To summarise, the low interest rate policy led to a wrong intertemporal price of consumption – consumption was too cheap today relative to the future – which led to excess spending and trade deficits. It also led to a mis-pricing of housing, which led to excess residential investment and excess borrowing by households. That is the price that was paid to make the 2001-2002 slowdown milder.

These imbalances have to be corrected. In principle, consumer spending can be brought down without the economy having to go through a recession, provided there is a sharp real depreciation of the US dollar, which would shift the structure of demand away from domestic spending and in favour of exports. On the other hand, the correction in house prices is likely to be contractionary. Some consumers have borrowed against the capital gains they made on their house, to purchase, for example, a second house or consumer durables. They are going to cut their consumption since they are more likely to become insolvent. As the collateral value of their houses falls, consumers will get less credit; hence a further drop in consumption. Furthermore, the securities backed by mortgages, subprime or otherwise, have been used as collateral by financial institutions; that collateral is worth less, thus reducing credit between those institutions. As a consequence, they will have more trouble lending to firms, so that investment will also be hit. The housing bubble has jeopardised the financial sector both because people have borrowed to hold it and because institutions have used the corresponding securities as collateral.

Because of this gloomy scenario, the Fed has been under pressure to cut rates. The problem is that such a policy is likely to perpetuate the current imbalances. Indirectly, it amounts to bailing out the poor loans and poor investment decisions made by many banks and households in the last five years. The bail-out comes at the expense of savers and new entrants in the housing market. The signal sent by the Fed is that it is sound to join any market fad or bubble provided enough people do so, because one will be rescued by low interest rates once things turn sour. Worse, the more people join, the greater the lobby in favour of an eventual bail-out.

All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.

The Asymmetric Effects of Monetary Policy: Texas vs. Michigan

In several previous postings (here, here, and here) I have commented on the stark contrasts between the economies of Michigan and Texas. Part of my motivation for making these posts was personal. I was trying to sell a home in the depressed Michigan economy after moving to a new job in the vibrant Texas economy. Another motivation, though, is that a colleague and I have been working on a paper (for the SEA meetings in New Orleans) on the asymmetric effects of monetary policy. Specifically, we are looking at the differential impacts of monetary policy shocks across the contiguous 48 states for the period 1979-2001. We follow some previous work done on this topic--see Ted Crone's survey--but add some innovations along the way.

One of our findings, consistent with that of the earlier research, is that monetary policy shocks have a non-uniform impact across the state economies. Monetary policy shocks are particularly poignant in the Great Lakes region while they largely uneventful in the Southwest regions. Of course, my previous Texas-Michigan discussions fall nicely into these two camps. So from our paper, I have posted below graphs that show the typical response--the solid lines--of real economic growth on a monthly basis for these two economies from a typical monetary policy shock. I have also included the typical U.S. response as a benchmark. Standard error bands, which help provide a sense of precision of these estimates, are shown by the dashed lines. (Technically these graphs show the impulse response function from a near-vector autoregression of the growth rate for each state economy, as measured by the coincident indicator, to a standard deviation shock to the federal funds rate.)

The differential responses of these two states to the same monetary policy shock are striking. Texas is hardly affected relative to the steep downturn in Michigan. As noted above, these patterns fall more broadly into the regions of the United States with different sensitivities to the federal funds rate shocks. Our research confirms early studies that show these regional differences can be partly explained by the composition of output: those states with a relatively high share in manufacturing get hammered by a monetary policy shock while those states with relatively high shares in extractive industries fare much better. We also find that states with a relatively high share in the financial sector fare better as well. Finally, we find that states that have (1) a relatively high share of labor income compared to capital income and (2) a relatively high rate of unionization also get hammered by monetary policy shocks.

Here is the rest of the paper.

House prices and the stance of monetary policy

A new paper provides further evidence on a view (see here, here, and here) promoted by this blog: past monetary profligacy contributed to the U.S. housing boom-bust cycle. Marek Jarociński and Frank Smets of the European Central Bank in a conference paper titled House Prices and the Stance of Monetary Policy find the following:

In this paper, we have examined the role of housing investment and house prices in US business cycles since the second half of the 1980s using an identified Bayesian VAR... There is also evidence that monetary policy has significant effects on residential investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002 to 2004 has contributed to the boom in the housing market in 2004 and 2005.

I wrote a similar note on U.S. monetary policy and the U.S. housing boom. In my note, though, I use a different measure of monetary policy than the paper above and discuss the issue from a more Wicksellian perspective. Nonetheless, the conclusions are essentially the same: the Fed was too accommodative during the "deflation scare" 2002-2003 and was slow to return to normalcy thereafter.

More Ben Bernanke Pictures

This picture is from Rebel Traders:




And here is some new money from the Big Picture:

"Helicopter Ben" Pictures

Here are two pictures capturing what many observers now think of the Bernanke Fed given its surprise move yesterday. From DealBreaker comes this picture:

And from Radom Roger we have this picture:

Poor Ben Bernanke--he is going to have a hard time getting past this increasingly popular "Helicopter Ben" image. While entertaining, these pictures fail to acknowledge that the other FOMC members voted for the 50 bps cut as well. How come they are not taking any heat?

Update

Here is a cartoon that touches on themes developed in this blog:

The Fed's Big Suprise

The Fed surprised many observers today by cutting the federal funds rate 50 basis points rather than the expected 25 basis points. As a result, the FT reports stock markets across the world rallied, oil futures hit record highs, and the dollar hit a record low against the Euro. The FT also reports

"...the market[s] interpreted Tuesday’s action as signalling the start of a rate-cutting cycle, pricing in a virtual certainty of a further cut at the next Fed policy meeting in October and another on or before its January policy meeting."

This is apparent in the figure below from the Cleveland Fed. Using options on fed fund rate futures, this figure shows the estimated probability of different outcomes in the October FOMC meeting. This new belief in a rate-cutting cycle is evident in the changed probability for for the FOMC moving the fed fund rate to 4.50% in October. Today the probability hit 60.2%, yesterday it was only 30.4%. That is a dramatic change in market expectations. Apparently, the markets believe they have seen a new side to the Bernanke Fed.

Update

Brian A. in the comments notes a key implication of the above developments: the Fed has made itself a slave to the markets.

Where Will the Fed Funds Rate Go Tomorrow?

Since the much anticipated September FOMC meeting is tomorrow, I thought I would take a quick look at what the markets are thinking about the outcome of the meeting. The conventional wisdom is that the fed funds rate (ffr) target will for sure drop to 5.00%. The only questions is whether it goes to 4.75% or lower. Here is a graph from the Cleveland Federal Reserve bank that shows the probability of different ffr outcomes. These probabilities are calculated using options on fed funds futures. This figure shows a 48.6% probability of the FOMC pushing the ffr target to 4.75% and 44.4% probability of it moving to 5.00%--a close call.





Next look at the intrade contract for the ffr being equal to or greater than 5.00% by year end. The latest probability for this contract is at 15%. While this figure does not say at which FOMC meeting the ffr target will be lowered, it does say that there is a 85% probability the ffr target will be less than 5.00% by year end. Interesting times...

Central Bankers Who Appreciate the Distortions They Can Make

Central bankers in the U.K. and Canada are being thoughtful. They are thinking through the implications of trying to stem the current credit squeeze. Too bad there is not more of this discussion occuring at the Fed and ECB. The Financial Times reports:

A clear divide between the world’s leading central banks emerged on Wednesday over how best to respond to the credit squeeze and the abnormally high interest rates for lending between banks for periods of more than a month.

The European Central Bank pumped an extra €75bn ($103bn) into the financial system for a fixed period of three months in a bid to cut the interest rate gap between overnight funding and lending over longer maturities.

In contrast, the governors of the Bank of England and the Bank of Canada publicly doubted whether such action would work. Mervyn King, the Bank of England governor, also warned in a written submission to the UK parliament that this approach risked encouraging “excessive risk-taking and sows the seeds of a future financial crisis."

The ECB said last Thursday that it would pump three-month money into the system to “support a normalisation of the functioning of the euro money market”. Both Mr King and David Dodge, the Canadian central bank governor, said commercial banks were well capitalised and strong enough to absorb the assets of troubled off-balance sheet investment vehicles that need to be brought on to their books.

Speaking in London, Mr Dodge said he thought investors would be more careful to understand what is contained in complex products in future. “The responsibility does rest on the investor to make sure he or she understands the risk in the product they are buying,” he insisted.

The Federal Reserve, meanwhile, appears to occupy the middle ground. It has not extended the duration of its money market operations, but it has made 30-day money, renewable at the borrower’s request, available through its discount window.

Policymakers are expected to step up calls for more transparency in structured finance when European finance ministers meet in Portugal on Friday. Discussions also continue over possible responses, such as a review of bank capital standards or efforts to pool distressed assets.

A Recap of the Fed's Role in the 2003-2005 Housing Boom

To recap my 'Past Monetary Profligacy' theme on this blog, I have posted both empirical and theoretical discussions as to why U.S. monetary policy was a key part of the housing boom of 2003-2005. I have also referenced others in this blog who share a similar view on the Fed's role. These individuals include the following:

John Taylor: "Using an econometric model, Mr. Taylor says the Taylor rule would have told the Fed to raise the federal funds rate from 1.75 % in 2001 to 5.25% by mid-2005. Housing starts, around 1.6 million in 2001, would have peaked at 1.8 million (annual rate) in early 2004 then begun a gentle decline. In reality, the Fed cut the rate to 1% in 2003, then began raising it in 2004, only reaching 5.25% in mid-2006. Housing starts soared to 2.1 million by early last year and have since plummeted, to around 1.5 million. A higher funds path would have avoided much of the housing boom … The reversal of the boom and thereby the resulting market turmoil would not have been as sharp..."

The Economist: "Many of America's current financial troubles can be blamed on the mildness of the 2001 recession after the dotcom bubble burst. After its longest unbroken expansion in history, GDP did not even fall for two consecutive quarters, the traditional definition of a recession. It is popularly argued that the tameness of the downturn was the benign result of the American economy's increased flexibility, better inventory control and the Fed's firmer grip on inflation. But the economy also received the biggest monetary and fiscal boost in its history. By slashing interest rates... the Fed encouraged a house-price boom which offset equity losses and allowed households to take out bigger mortgages to prop up their spending... The Fed's massive easing after the dotcom bubble burst... simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place.

Tito Boeri & Luigi Guiso: "The first two factors [ of the current crisis, financial illiteracy and financial innovation,] aren't new. Without the third factor – the legacy of the 'central banker of the century' – the crisis probably would have never occurred. The monetary policy of low interest rates – introduced by Alan Greenspan in response to the post-9/11 recession and the collapse of the new economy “bubble” – injected an enormous amount of liquidity into the global monetary system. This reduced short-term interest rates to 1% – their lowest level in 50 years. What’s more, Greenspan spent the next two years maintaining interest rates at levels significantly below equilibrium. Interest rates were kept at low levels for a long time, and were often negative in inflation-adjusted terms. The result was no surprise. Low returns on traditional investments pushed investors and lenders to take bigger risks to get better returns. Financial intermediaries, in search of profits, extended credit to families and companies with limited financial strength. Investors with varying degrees of expertise duly reallocated their portfolios towards more lucrative but riskier assets in an attempt to increase their wealth and preserve its purchasing power. The low borrowing rates for both short and long-term maturity attracted throngs of borrowers – families above all who were seduced by the possibility of acquiring assets that for had always been beyond their means. At the same time, house prices soared, ultimately encouraging the additional extension of credit; the value of real estate seemed almost guaranteed. . .Thanks Alan! Today we’re paying the cost of your overreaction to the 2001 recession."

I am also working on a short note to be submitted shortly to a journal on this issue. I will keep you posted on its developments.

My Conversation with Ben Bernanke

Between 2003 and 2004 I worked as an international economist with the U.S. Department of Treasury. While there, I had the privilege of meeting Ben Bernanke. No, Ben and I did not sit down and have a one-on-one discussion on the economic issues of day. Afterall, I was a mere desk officer in international affaris and he was a Fed board governor at the time. However, I did get to escort Ben Bernanke from the entrance of Treasury to a meeting room and I took advantage of this opportunity by engaging him in a conversation. You can imgaine how excited I was to be hanging (all of 5 minutes) with someone whose work I had studied extensively in graduate school and who was now a Fed governor. I did not wash my Bernanke-handshaked hand for weeks.

This experience emboldened me to follow up by shooting him an email. In this email I asked Ben Bernanke--who was also the AER editor at the time--why there was not more research being done on productivity-driven deflation, given that it seemed a reasonable way to interpet the low inflation of 2003. To my surprise, Ben actually replied with a most interesting response. First, he said there was some work being done on this issue and pointed me toward Michael Bordo and Angela Redish's deflation paper. Then--and this was the shocker to me--he proceeded to justify the extreme lowering of the Federal Funds rate by noting the low capacity utilization rate and how it supercedded any productivity-driven deflation considerations. In other words, he acknowledged the possibility that benign deflationary pressures could be at work, but fell back on the low capacity utilization interpretation of the low inflation in 2003. Ben Bernanke believed most, if not all, of the low inflation of this time was due to a weakening of aggregate demand not a strengthening of aggregate supply. In his 2003 speech, "An Unwelcome Fall in Inflation?" he makes the same connection between low capacity utilization and low inflation:

"Although (according to the National Bureau of Economic Research) the U.S. economy is technically in a recovery, job losses have remained significant this year, and capacity utilization in the industrial sector (the only sector for which estimates are available) is still low, suggesting that resource utilization for the economy as a whole is well below normal... [this] persistent slack might result in continuing disinflation..."

There are, however, theoretical reason why capacity utilization may not be closely tied to inflation and there is empirical evidence showing this metric to be a poor forecaster of inflation. On the first point, some argue that globalization has made domestic capacity constraints less meaningful. Other observers note that the link between capacity utilization and inflation is premised on demand being the main driver of inflationary pressures, when in fact supply shocks can also be important. I find this second argument the most compelling because it was during this very time (2002-2004) that produtivity growth was increasing (see my productivity graph). One the second point, I direct you to a Dallas Fed study showing the capacity utilization and inflation relationship breaksdown after 1983. Also check out the Stephen Cecchetti and friends study that shows capacity utlization to be one of the worse inflation predictors. In fact, this study shows that capacity utilization relative to an autoregrssion actually reduces the accruacy of forecasting inflation.

Why am I sharing all of this with you? Because it is germaine to question of whether the deflation scare of 2oo3 was mishandled by the Federal Reserve. Now Ben Bernanke was only a governor at the time, but his view is probably a good representation of what the Fed was thinking: low inflation => low aggregate demand => low interest rates needed. As I have stated elsewhere on this blog, what they should have been thinking is low inflation low inflation => robust productivity growth => no need to cut rates (maybe even raise them).

Update
I went ahead and did some preliminary analysis of my own on the relationship among inflation, capacity utilization, and productivity. Specifically, I ran a distributed-lag regression with the q/q CPI inflation rate as the dependent variable and regressed on it the industrial capacity utilization rate and the q/q non-farm business sector productivity growth rate for the years 1967:Q1 -2007:Q2 (all data is from the FRED database). The regression included 8 lags plus the contemporaneous value of each right-hand side variable in the regression. The distributed-lag regression was run such that dynamic cumulative multipliers were estimated. Next, I applied one standard deviation of each right hand side variable to its cumulative multipliers and come up with the graph to the right. Here, the cumulative response of inflation over time to both series receiving a a one-standard deviation shock is portrayed. Confidence bands of 95% are marked by the dashed lines. Note that the effect of a productivity shock is far larger than the capacity utilization shock. The productivity shock causes a permanent decline in inflation of about 0.9%, while the capacity shock effect is teetering around a 0.1% increase. Moreover, the capacity utilization shock for the most part creates a response not significantly different than zero. The q/q inflation rate averaged 1.1% over the period of this sample, so the statistically significant 0.9% decline of inflation to productivity is a non-trivial response.

These results are preliminary and show only the typical response over the sample, but at a minimum they should give pause to consider that just maybe the low inflation of 2003 was due to the robust productivity growth rather than the low capacity utilization rate.