September 25, 2005
Responding to supply shocks
It seems pretty clear to me that a monetary contraction isn't the appropriate policy response to a supply shock. Apparently there are those within the Federal Reserve who see things differently.
Last week's statement from the Federal Reserve acknowledged that the damage from Katrina could well mean both lower output and higher inflation:
Output appeared poised to continue growing at a good pace before the tragic toll of Hurricane Katrina. The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term....
Higher energy and other costs have the potential to add to inflation pressures....The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal.
With those words, the Federal Reserve bumped the fed funds rate up to 3.75% at its meeting last week, and the market seems to expect another increase at the next meeting as well.
First of all, let's be clear about terminology here. Just because the Fed has been raising the interest rate at each FOMC meeting for over a year, we shouldn't think of yet another rate hike as representing no change in policy. The Fed may care about both output and inflation, but over a short time horizon it only has the tools to address one objective at a time. In raising the interest rate in the current environment, the Fed is making a deliberate policy choice to sacrifice the output goal in order to achieve a more favorable result for inflation.
How should news that we're going to perform worse in terms of both objectives lead us to re-evaluate the tradeoff between the two? The answer depends in part on how you think about fluctuations in the unemployment rate. The graph at the right displays the unemployment rate in the U.S. over the last half century, with recessions indicated by shaded areas. One striking feature about this series is the fact that the unemployment rate tends to rise much more quickly than it falls. Statistical confirmation that this is an important feature of the data is reviewed in this recent paper. To me this asymmetry suggests that there is a potential cascading effect of an economic downturn-- if a large enough mass of people lose their jobs, that fact in itself creates an impetus for even more layoffs. Once that process begins, the economy goes into a recession too quickly for the Fed to be able to prevent it. I would argue that the most important guideline for the Fed in terms of balancing the growth and inflation objectives is to make sure that the efforts to keep inflation low never go so far that they cause us to enter that regime of a rapidly spiking unemployment rate.
The issue is that the recent supply shocks have surely increased the probability of that happening. Rapidly rising energy prices have often preceded economic recessions. Although prior to August the oil price increases had developed gradually enough that the economy was largely able to adapt, my earlier concerns about airlines (here and here) were borne out last week by Delta Airline's announcement that it intends to eliminate 9,000 jobs. The rapid rise in gasoline prices since August did seem to cut into retail sales, and the post-Katrina plunge in consumer sentiment must be interpreted as a very loud warning bell. The destruction of New Orleans also looks to me like an event that could have significant macroeconomic consequences. Ed Leamer may be correct that a recession won't occur without a housing downturn. But if perceptions about housing price appreciation and the economic outlook change, a housing downturn could come pretty quickly, and certainly there are some signs already of a cooling housing market (, ).
Even apart from the supply shock, we do have some historical experience with what happens when the Fed raises interest rates by 275 basis points in a little over a year, as they've just done. When the Fed did the same thing in 1959, 1969, 1973, 1978, and 1989, we ended up in a recession. On the other hand, in 1984 and 1995 we managed to dodge the bullet.
I suppose that the Fed thinks it's smart enough to take its foot off the brake at just the right moment this time around, too. But how do we know when "just the right moment" is? Didn't the Fed think it was being smart in 1959, and 1969, and 1973, and 1978, and 1989 as well? I agree with Socrates that wisdom comes from being aware of what you do not know. We don't yet know what the macroeconomic implications of Katrina will prove to be. If the Fed really wants to be smart, it will wait until we have a better understanding of that before kicking rates up yet another notch.
Posted by James Hamilton at September 25, 2005 02:28 PMdigg this | reddit
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You may be right about what the Fed should be doing now, but I have a hard time thinking the Fed should have been more cautious about tightening in 1969, 1973, and 1978. Strictly speaking, if the objective is just "to keep inflation low" -- that is, if the inflation rate is already low -- then risking a recession might indeed be rather foolish. But in those cases, where there was a pattern of rising inflation rates in place, was not the Fed perhaps correct in thinking that it was being smart to err on the side of risking recession rather than risking more inflation?
Posted by: knzn at September 25, 2005 05:52 PM
The Fed has one actual weapon; short-term interest rates. A VERY unfocussed response. It can also jawbone.
Monetary policy has been accomodative for several years. Does it make sense to continue an accomodative policy when a very small fraction of the US is hurt, and there will be massive targeted government spending in the affected area shortly?
When rates were 1% it really took guts to borrow and invest. There was very poor demand. Now the economy is humming, and it is far less risky to borrow to expand a business at current rates. What earthly reason is there to keep the price of money low in these circumstances? It merely discourages savings, which I'm told is in short supply in the US. Perhaps that's because the savers in the US have been discouraged from saving due to administered rates that don't recoup taxes and inflation.
Posted by: Rich L at September 25, 2005 06:20 PM
Hi, A rare disagreement with your posts. The Philips curve idea is a dangerous game that we played and lost badly in the 70s. The evidence of the last two decades suggests strongly that the central bank should focus on achieving an inflation objective, first and foremost, and then secondarily, growth objectives, but only to the extent that they are compatible with the former. The question may then become how to define that inflation objective both in terms of the basket - headline, core, PCE deflator, etc - and level of inflation. I think you would have been closer to the mark arguing that the Fed should not target headline, but rather raise rates only to manage core and hence avoid overreacting to a supply shock that should (I stress "should") act as a negative hit to disposable incomes.
I would argue you are making a mistake in the assignment problem issue. The central bank is best equiped to target inflation stability, not growth. The government is better equiped to target growth via fiscal policy, despite its lags. Thus, the Fed focuses on achieving its inflation objective and the government uses fiscal policy to manage unemployment, preferably focusing on structural issues that improve labor, product and capital market efficiency to make the economy better able to adjust relative prices to resorte equilibrium rather than just handing out cash or even tax cuts. But, at times, countercyclical fiscal policy will require direct transfers.
Posted by: rf at September 25, 2005 06:28 PM
To add to the above, the Fed needs to tighten before core rises to prevent it from rising and raising the general price level permanently. Forecasting core is tough. However, a general guide that should be robust would be to say that when the economy is operating above potential, higher core inflation should follow. And the evidence is that the economy is running above potential:
a) the current account deficit is widening
b) employment is rising, unemployment is falling, and the unemployment rate has fallen below its 10yr trend
c) productivity growth has slowed and unit labor costs are rising at close to 4%
d) even Uncle G admits that the housing market is showing signs of "froth"
e) for what it may or may not be worth in this analysis, the saving rate has collapsed. I add this because it augurs ill for future investment and productivity growth and thus for the capacity of the economy for noninflationary growth at current rates.
So, until it is clear that the consumer holds to his recent survey responses and stops spending, the Fed is probably right to keep tightening.
Posted by: RF at September 25, 2005 06:46 PM
The trouble with targeting BOTH inflation & growth simultaneously is that they neither parallel nor orthogonal... they share some variables but have variables all their own.
I really think the fed's weapons (or weapon - singular) works better in high innovation, high productivity, high growth environment than it does in slower innovation-productivity-growth speculative environments... And I think we are well along the way from the former (late 80s to late 90s) and into the latter (when it end ?)...
I think if you are looking for the Fed to fix the ills that afflict us... then you will wait a long time & in vain.
Posted by: dryfly at September 25, 2005 07:59 PM
Inflation is increasingly controlled by markets that extend beyond our borders. This makes monetary policy a crude weapon for combating inflation. By raising short-term interest rates, the Fed diminishes consumer demand, but it also raises the value of our currency and thus lowers the cost of imported goods. Fed policies are becoming much less important in managing our economy.
The most significant threat faced by our economy is not inflation driven by consumer demand, but the huge debt that consumers are amassing. Rising fiscal deficits are another threat. These threats will continue to accelerate until we crash. There is no rosy scenario for the US economy.
Posted by: touche at September 25, 2005 08:20 PM
Which is the more important task for our central bank - controlling inflation or keeping unemployment low? This is a controversy going back many years and I suppose we'll have to figure out our own answer in 2005. If the job of the Fed is to "take away the punch bowl just when the party gets going", doing so when everyone is thirsty creates conflicts - (sorry for the overblown analogy.)
Personally, the underlying economic issues are physical and Mr. G's speeches about energy shows that he shares that opinion (to some degree). Of course, his only power over energy is giving speeches and lecturing Congress.
As to Katrina's MICROeconomic effects, I see that New Orleans Power System Inc (I know it as NOPSI - noop-see) has declared bankruptcy. This is a unit of Entergy, the big utility holding company. They claim that the cost of damage repair exceeds the book value of the company and that the unit is out of cash since their customers moved away. Guess this will open some Federal purse strings for them and keep control out of the city council and under a federal bankruptcy court judge. They might need half a billion or so.
One sees this organizational form in other locations. Utilities like to be able to isolate the liberal big cities into a separate unit so that the corrupt city politicians exploitation is constrained to their own consitiutents. Detroit Edison and Potomac Electric are examples. PG&E would love to serve the people of San Francisco without their pesky politicians.
Posted by: Joseph Somsel at September 25, 2005 10:54 PM
It seems to me the only response to a supply shock is "monetary contraction" to bring demand in line with supply. This assume that supply cannot be made up from domestic or offshore sources. "Monetary ease" would only make things wosrse if this was the case.....either way it is an inflationary event unless demand is slowed to meet the reduced supply.
Posted by: Hondo at September 26, 2005 08:36 AM
> These threats will continue to accelerate
> until we crash.
I wish some macroeconomist found it within his powers to paint a detailed picture of how this event might play out. It's interesting that even though the market has established a bottomless appetite for economic disaster books no one competent, or for that matter incompetent, has to my knowledge published a book about the great Crash of 2010. Jim Fallows had a piece in the Atlantic a year ago that was entertaining enough but skipped over the event itself in a sentence. Suppose the appetite of foreigners for US bonds trails off and the US hikes yields. And hikes them again. And again. What will happen? How will the Fed respond? Will Congress be more or less likely to increase taxes and cut benefits as the tales of distress mount? What happens if it is paralyzed?
What will this do to "consumer confidence" with what implications for the economy (and tax receipts)? Would the US try to inflate its way out of the problem? How would the Fed react to that?
Posted by: Fred Hapgood at September 26, 2005 09:42 AM
Leave it to Alan to understate the obvious...
Federal Reserve Chairman Alan Greenspan told France's Finance Minister Thierry Breton the United States has "lost control" of its budget deficit, the French minister said Saturday.
Posted by: dryfly at September 26, 2005 10:13 AM
When will the discussion start distinguishing between inflation caused by monetary expansion versus inflation caused by supply shocks?
Inflation caused by monetary expansion is controllable by the Fed. Inflation caused by a supply/demand shift is completely beyond the Fed's capacity to deal with it. In the case of oil supplies tightening, if the Fed tightens, sucking money out of the economy will simply be the 2ND factor choking economic growth after oil prices. The tightening will have little impact on real prices because the excess demand for oil is overseas and beyond the Fed's reach. Yes, they can punish U.S. citizens, reducing OUR oil demand - but not China's and India's.
If the Fed sees the oil shock as a cause of concern and loosens monetary constraints, our cheaper currency will cause oil prices to rise. It won't help.
The only raison d'etre for the Fed is to keep our money supply balanced. If they do that, stable prices MAY result. Any other goal only serves to make matters worse.
Posted by: bk at September 26, 2005 11:19 AM
I think the Fed sees fiscal policy as out of control and therefore they have no choice but to tighten to counter it.
Posted by: Lord at September 26, 2005 12:24 PM
James is simply wrong.
Real interest rates are about zero and clearly excessively accomodative, leading to enormous speculative trading in the housing market and a dangerous lowering of lending standards.
It's not clear where the "neutral" real rate is, but in an economy with 4,9% unemployment it's obviously not zero and Alan knows it.
Posted by: RN at September 26, 2005 12:28 PM
In the peoples republic of San Francisco the number of unbought houses for sale has increased 100% in the last two weeks according to some very knowledgeable full time R E dealers. What happens if all of James negative scenarios-or even some of them-come about? The last time we had a few stack up, gold went to an inflation adjusted price of about $2000 per ounce. I hear a giant clucking sound.
Posted by: howard weston at September 26, 2005 05:26 PM
Dryfly, be careful not to confuse inflation, a rise in the general price level, with a change in relative prices. The Fed, if it chose, could force a reduction in demand for goods other than those related to the cost shock such that prices for these goods (and services) fall leaving the overall price level unchanged. Oil prices would be higher but, say, haircuts would be cheaper. I'm not saying that the Fed should be quite so strict. Rather, I am saying that the Fed should chose some measure of the price level, call it "core," and focus on stabilizing this.
Posted by: RF at September 26, 2005 05:32 PM
"Would the US try to inflate its way out of the problem?"
We can only hope. This should be the first priority of the politicians that inherit this fiasco.
Posted by: touche at September 26, 2005 06:26 PM