July 25, 2005
Why the Fed needs to slow down
The Fed has promised to keep on raising interest rates at a "measured pace." I just prefer they'd measure their pace a little more slowly.
The market's latest guess about where the Fed's headed is up at Macroblog. Fed funds options traders seem to think that more likely than not, the fed funds rate will be up to 4% by November. Why does that strike me as a bad idea? Let me count the ways.
(1) Autos. A big increase in oil prices has often been a precursor of an economic downturn. One important mechanism for this correlation appears to be sudden changes in the kinds of cars that households buy, leaving U.S. automakers holding an empty bag. That's been avoided so far this time around, partly because the oil price and car demand changes have occurred over a much more drawn out length of time compared with some other episodes, and partly because GM was able to forestall some of the sales drops with its aggressive employee discount program. Although this has kept sales propped up, GM's North American operating division posted a $1.2 billion operating loss in the second quarter. I'm reminded a little of the old Roadrunner cartoons in which Wile E. Coyote runs off the cliff, suspended in the air for a few minutes by simple belief that the ground is still there, until the inexorable force of gravity takes hold. Something's going to have to change here pretty quickly. Meanwhile, Autoweek reports that Ford's North American capacity utilization is running at 75% with additional plant shutdowns likely.
(2) Housing. I have argued that the U.S. house price appreciation is not a "bubble" in the sense that economists use that term, but instead was driven largely by economic fundamentals, in particular record low mortgage rates. But I've also joined Marginal Revolution and the Big Picture in noting that this means that now that interest rates have moved up, house prices could fall quickly on further rate hikes. The extent to which people have stretched on interest-only and adjustable rate mortgages makes that potentially a very unpleasant scenario. Furthermore, housing appears to have played a very important role in the recent growth of the U.S. economy, a point that has long been stressed by the Big Picture, General Glut, and Calculated Risk, among others. Indications of a housing slowdown are now coming in from Sacramento, Boston, and D.C. All that is needed to cool down the housing markets further is holding steady right where we are now. A sudden jerk on the reins and an economic recession could easily put us into a situation of some rather ugly bankruptcies.
(3) History.As I noted here, this is starting to look a whole lot like a place that we've been many, many times before. The Fed overstimulated the economy in 2002-2003, and, worried about the result, now is trying to slam on the brakes. The problem with both modes is that whatever the Fed does, the economic consequences don't show up until many months later. The Fed is again looking out the side window of the car right now. It sees that the economy hasn't slowed too much, so it thinks that further application of the brakes must be called for. But the question isn't where the economy is right now, the question is, where will the economy be in December? It seems to me a definite possibility that we'll be in a situation in which we'd very much regret some of that brake-slamming.
Those strike me as three good reasons for the Fed to slow down and catch its breath before moving interest rates much higher. How many reasons do we need, anyway?
Posted by James Hamilton at July 25, 2005 06:16 PMdigg this | reddit
Listed below are links to weblogs that reference Why the Fed needs to slow down:
» Should the Fed Pause and Catch Its Breath? from Economist's View
Here’s another view of Fed policy from John Makin of AEI, but not one I fully agree with since it implies the Fed is focused on housing. The Fed has made it very clear that it does not intend to [Read More]
Tracked on July 25, 2005 09:18 PM
» Why the yield curve matters from Stumbling and Mumbling
Alan Greenspan and the Conference Board could both be wrong, according to a paper in the latest Economic Journal. Mr Greenspan recently told the Joint Economic Committee that the yield curve is not a foolproof indicator of a downturn (pdf). [Read More]
Tracked on July 26, 2005 03:26 AM
Well 1) it seems the Fed is gaining little to no traction on long term rates, so a little shock may well be in order to shake out some of the imbalances that have caused the big mess in the first place, and 2) the real overnight rate is still nearly zero, hardly what most would hope for as a neutral rate in an overstimluated lending environment.
The Fed is the only responsible actor at the moment. The Federal government, the mortgage banking industry, and until recently China (and only barely now) are all contributing seemingly uncaringly to the problems, with no sense of foresight whatsoever. I applaud Greenspan for potentially risking a piece of his legacy in his last few months by trying to do the right thing.
Posted by: JohnHar at July 25, 2005 08:49 PM
Professor: strong arguments and I'd definitely like to see the FED negotiate a soft landing. But I keep wondering - what is so wrong with the economy that the FED has had to hold rates at emergency levels for almost four years and can't return rates to neutral?
Perhaps raising rates will show: 1) there is nothing really wrong with the economy or 2) expose the structural problems and force us to deal with them.
Posted by: CalculatedRisk at July 25, 2005 09:35 PM
Is there any kind of a free market or decentralized model which could take the place of the Fed's seemingly erratic attempts to keep the economy growing steadily? Of course the Fed was created in part due to the failure of the old decentralized system, but are there new theoretical results in economics that could point to a better system?
Posted by: Hal at July 25, 2005 09:51 PM
Hal, I must say that the record before the Federal Reserve was established in 1913 was not a good one that anyone would want to go back to. I'm certainly not opposed to the Fed as an institution. In my view, the problems come from the Fed attempting to do too much, thinking that with strong jerks in the interest rate up or down they can help guide the economy on a more perfect path. I believe some of our problems at the moment came because the Fed moved interest rates down too far and too fast, and they're just setting up the next problem by now going too far and too fast in the other direction.
Posted by: JDH at July 25, 2005 10:14 PM
The Fed hasn't figured out how globalization has diluted the effectiveness of its policies. Inflation is mostly determined by global supply and demand and less and less by its policies. Greenspan is Don Quixote.
Posted by: touche at July 26, 2005 08:46 AM
To the Fed's defense some of the above discussion sounds a bit like monday morning quarterbacking. It's easy to criticize their decisions once you know the magnitude of the shocks they were trying to guess and react to. Also in their defense, knowing what sort of a recession a mega-terrorist attack on the United States can generate without monetary easing was extremely difficult to guess in the absence of historical precedent.
Nevertheless, I think I do aggree that there is a systematic pattern of over-reaction at the Fed, which I think is attributable to higher than normal aversion of extreme instances of high inflation or unemployment, at least compared to the rest of us, mortal participants to aggregate economic life.
Then again, they have the institutional memories of these events, and they know how (non-linearly) disruptive to society these episodes are whereas we tend to forget about these low probability but high cost events (typical behavioral bias) and focus on the cost of avoiding them, which may include suffering through some self-inflicted cycles as we struggle to drive safely to our destination by looking in the rear mirror.
Posted by: Jean-Philippe Stijns at July 26, 2005 02:39 PM
Isn't this best capsulized in this comment from Lawrence Lindsey:
"We have done what no other economy has done before, faced with an asset bubble. This is the first time in history the textbook economic policy was used and worked. The problem is, once you finish that chapter of the economic texts, you turn the page and the page is blank -- because no one has gone through the process before."
To continue to raise rates risks killing off the bad growth that was created to minimize the effects of stock market bubble bursting. To stop raising rates risks an even bigger bubble.
So what do you do, aside from cross your fingers?
Posted by: Tim at July 26, 2005 05:06 PM
I fully agree with the points made by Prof Hamilton. However, there are two valid reasons why the Fed may want to continue to raise rates.
1) To defend the foreign exchange value of the US Dollar.
2) To make the job of a new Fed chairman easier. (It is always more popular to lower rates than to raise them).
Posted by: Robert Sczech at July 26, 2005 08:40 PM
Macroblog has some interesting postings on how well the Fed's actions can be approximated by a "Taylor rule" which sets the federal funds rate based on production levels and inflation. His most recent posting on the topic is http://macroblog.typepad.com/macroblog/2005/06/unfinished_busi.html and the chart showing how close they come is at http://macroblog.typepad.com/.shared/image.html?/photos/uncategorized/taylor_rule.gif .
Posted by: Hal at July 26, 2005 09:00 PM
Responding to your original points of concern:
1. To the extent that the Fed should care at all about the health of the auto industry, it should be measuring unit sales, not the profitability of US auto manufacturers. Re units, the staggering incentive-driven surge is if anything a sign of too-easy money. And it is certainly beyond the power of the Fed, the feds and probably anyone to do much about the dysfunctional structure of the auto industry.
2. I don't know if housing is a "bubble" in a formal economic sense. That prices in many markets are outstripping the ability of many/most families to afford housing in a prudently-financed manner is indisputable. It is the job of market to punish imprudent or irrational decisions. It is not the job of the Fed to prevent the market from doing its job. If rising rates force many recently-overlevered households into bankruptcy, there is not much the Fed can or should do about it.
3. The Fed has been overdoing it in both directions since it was created. Jean-Phillipe Stijns' post above provides an insightful reminder that a major aspect of the Fed's responsibility is political/strategic; who's to say that the Fed was too loose in the aftermath of 9/11? But it was very loose, and appears to be doing a reasonable job at removing the stimulus in a nondisruptive way.
If I were Greenspan, I'd keep going.
Posted by: Joe Doyle at July 27, 2005 05:53 AM
You're right that the Fed can't solve GM's problems, Joe. But the relevance of GM is this. The Fed is trying to raise rates in order to slow down the economy. If autos are about to tank, the economy will slow down plenty, and there's no need for the Fed to kick it on the way down.
On housing, you can teach those borrowers a lesson, but recessions and cascading bankruptcies aren't good for anybody. All a reasonable person should want to accomplish here is a gradual, controlled decline in real estate prices. The question is a factual one as to whether we've already done enough to ensure that's going to happen.
And if I'm wrong in my assessments about those two sectors, I don't see the harm in waiting a few more months to find out for sure before kicking the fed funds rate up to 3.75 or 4.
Posted by: JDH at July 27, 2005 07:14 AM
JDH -- How do you respond to the fact that unit employment costs have risen at a 4.2% year-on-year pace as of 3/31/05? Unit labor costs were flat to negative between 1Q00 and 1Q04. The trend since 1Q04 has shown a steady increase. (Source is Bloomberg economic data. COSTBUS) Because unit labor costs are closely tied to future inflation -- correct me if I'm wrong -- the Fed does appear to be looking through the windshield.
Posted by: jult52 at July 27, 2005 08:14 AM
Hmmmm...is the Fed targeting the economy, or inflation, or both, or something else? I'm sure we all could argue all day long about that one, and the fact that we'd all argue is one of the downsides of the Greenspan era of judgemental monetary policymaking. And if the Fed were (or should be) targeting the economy, are auto unit sales the right indicator to look at? I guess I'm not convinced.
On housing, I'm very sceptical that it is reasonable to expect (or hope) that we can achieve a gradual, controlled decline in real estate prices, anymore than it was reasonable to expect a gradual, controlled decline in investment in telecommunciations infrastructure before the last bubble burst. Human nature being what it is, markets overdo it on the way up, and on the way down, too, and lots of people get hurt. I am operating from the premise that the Fed overstimulated post 9/11 and throughout the ensuing equity bear market to ensure that the US economy stayed strong enough to finance a war effort and/or remove the risk of deflation. I oversimplify at the risk of sounding like a conspiracy theorist, but whatever the policy motive its pretty clear they overstimulated. The Fed now has an obligation to make sure they remove the stimulus lest it lead to inflationary pressures (without regard to the fortunes of individual economic subsectors), and my read is that they are not done yet.
You are probably relieved that it is Greenspan's judgement, and not the judgement of someone like me, that is driving this train. But that begs a question: what are the odds that Greenspan's successor will possess the qualities of judgement equal to or superior to Greenspan? And is the risk of someone not as skilled becoming Fed Chairman properly priced into the markets? Policy mistakes will be made, but how big will they be?
Posted by: Joe Doyle at July 27, 2005 08:28 AM
Joe, I enjoyed your posts UNTIL I read your accolades to AG. He's an Ayn Rand groupie whose desire to please his leader-of-the-day has caused way more harm than good. No, it's not ALL his fault, but he was supposed to be independent. If he was unable to influence the Administration away from so many of their harmful policies (behind the scenes), he certainly could have neutralized their painful effect earlier. IMO he's directly responsible for how big they will be.
Posted by: bailey at July 28, 2005 12:18 PM
Joe, And YES, I greee he should keep going - all the way to 5%! But, we all know how unlikely that is.
Posted by: Bailey at July 28, 2005 12:21 PM