7 posts tagged “federal reserve”

On the Radio: mp3 files:

At night in the suburbs of San Francisco, some of us awake as the hills echo and re-echo with the howls of the coyotes that have fed well on Glenn Rudebusch's chickens. We then lie awake, worrying. We worry why the Great Moderation in the U.S. business cycle on the real side that we have seen since the mid-1980s has not carried a big reduction in financial-side variability with it. We toss and turn, worrying that the real-side volatility decline has been part good transitory luck and part statistical illusion, all because people in financial markets putting their money where their mouths were do not project the continuation of the Great Moderation into the future.

Christina Wang's paper lets us sleep more easily, even if the coyotes continue to prey upon the chickens of Federal Reserve Bank Vice Presidents. It teaches us an important and valuable lesson: a financial system that is doing a better job will be highly likely to have both higher financial and lower real volatility.

When a firm goes bankrupt and defaults on its debt, it may be because it has had bad luck, it may be because it was badly managed, or it may be because it suffered from moral hazard--took account of the fact that in the lower tail the losses are eaten not by the firm but by the bank that loaned it the money. Banks that have a hard time distinguishing between these possibilities will be averse to lending--charge a high interest rate premium on loans--to firms seen as having a high degree of undifferentiated idiosyncratic risk. Improvements in data collection and analysis that allow firms to differentiate will cause banks to fear undifferentiated firm-level idiosyncratic risk less, and charge lower interest rate premiums for such lending. Other things being equal, firms will smooth production more, and smooth cash-borrowing requirements less, seeking to squeeze out more productive efficiencies by taking on more financial risk. To the extent that improvements in data collection and analysis reduce banks' fixed costs of monitoring loans, other things being equal banks will do more to diversify away firm-level idiosyncratic risk.

When a bank goes bankrupt and defaults on its debt, it may be because it has had bad luck, it may be because it was badly managed, or it may be because it suffered from moral hazard--took account of the fact that in the lower tail the losses are eaten not by the banks' shareholders but by those who hold or guarantee its liabilities. Improvements in data collection and analysis by those to whom banks owe their liabilities will allow them to better classify banks, and so the cost to banks of portfolios with bank-level idiosyncratic risk will fall. Other things being equal, banks will be willing to take on more bank-level idiosyncratic risk.

Of course this function that Christina Wang identifies is the primary job--one of the primary jobs--of financial markets: to diversify away idiosyncratic risk, as was ably explicated by that notable predecessor of Lintner and Markowitz, William Shakespeare. As Shakespeare writes, Antonio, the Merchant of Venice, does not fear that the lower tail of his portfolio return distribution extends far enough down to the state in which his heart is cut out with a knife. Antonio he has a properly-diversified portfolio. The banker lending him the money uses the highest information technology of that day: wandering down to Venice's Grand Canal, loitering on the High Bridge, and gossiping. The banker concludes that Antonio has:

an argosy bound to Tripolis, another to the Indies; I understand moreover, upon the Rialto, he hath a third at Mexico, a fourth for England, and other ventures...

Here the analogy breaks down. Negative transitory systematic news does indeed provoke a crisis in Antonio's affairs, but he is rescued not by a competent, technocratic lender of last resort but by his bride disguised as a teenage judge.

Christina Wang hopes that starting sometime in the mid-1980s we took a jump toward the ideal financial world in which one of CAPM's cousins holds, in which idiosyncratic risk is not priced because it is properly diversified away, and in which as a result the real economy can grab for all the production-smoothing efficiency benefits without worrying about firm- or bank-level costs of default or illiquidity. This shift could drive a reduction in real-side volatility coupled with an increase or no change in financial-side volatility.

She has a nice theoretical costly-state-verification model of the effects of improved data collection and analysis technologies. She has a very interesting theoretical Dixit-Stiglitz-based three-period model of the joint determination of real and financial volatility. The key insight is a very good one: that production-smoothing has not just manufacturing-side and labor-side efficiency benefits but financial-side efficiency costs: only if banks are confident in their ability to monitor firms and large depositors confident in their ability to monitor banks will firms be able to easily and cheaply borrow the money they need in recession to enable a production-smoothing corporate strategy. The fact that times of recession are times when a firm's free cash is likely to be uniquely valuable and not to be best invested in building up inventories is a potentially powerful explanation of why we have, historically, seen the reverse of production-smoothing in the American economy. She has interesting empirical results that suggest that banks and firms have reacted to a likely information-driven fall in the cost of idiosyncratic financial risk to take on more of it. The theory is sound and convincing. The micro empirics are interesting and suggestive.

But how much can this channel add up to on the macro level? How, exactly, does ICT help bankers? Working for the original J.P. Morgan, Charlie Coster was on the boards of 88 railroads at the turn of the last century and died of overwork--Morgan is reputed to have recruited Coster's successor while they were together carrying Coster's coffin to its grave. What would today's ICT have done to increase Coster's contribution to Morgan's bottom line, exactly?

And how much of the Great Moderation in real-side economic volatility can this channel account for? Recall the size of the Great Moderation: a 40% fall in the standard deviation of the cyclical component of GDP, more or less the same however you choose to measure it. A fall in spite of the fact that technology and cost shocks have in all likelihood been quantitatively greater in the past ten years than in any other post-WWII decade save possibly the 1970s.

As Christina Wang says, her paper as written can't do the job. It can only do about a third of the job--although Doug Elmendorf said half last hour. The model as extended quite possibly could.

In this literature, the game that is being hunted is the positive correlation between production and inventory investment that we saw in the past. In a standard production-smoothing model inventory investment should be relatively high when production is relatively low, and sales are very low. Instead--back before 1985--inventory investment was high when production was high. This shift could be possibly traced to Christina Wang's mechanisms. But it can account, in my back-of-the-envelope guess, for not a 40% but a 15% decline in the standard deviation of the cyclical component, whatever that is.

The big game for this model--as Chistina Wang says in her conclusion--will, I think, come from applications of models like this to the household sector. It's not just firms that have benefitted from the application of information technology to credit screening. I have gotten three offers of VISA cards and two offers of what were described as "guaranteed low interest" home-equity loans so far this week. Plus the people behind the counter at my most local Starbucks have started asking me if I'm interested in a no-annual-fee Starbucks VISA that will come with $25 of free caffeinated drinks. I don't know whether they are doing this to everybody or whether there is something special in my file. The smoothing-out of household durables purchases will, I think, be an important part of the Great Moderation when we finally nail it down. And I think that's where the high returns from Christina Wang's model will come.

Last, the smoothing out of residential construction--if it indeed stays smoothed-out--may well turn out to be the heart of the matter. One branch of the conventional wisdom is that the smoothing-out of residential construction is a result of good luck that is about to end: that America's banks have been offered too much rice wine by the People's Bank of China, and have responded by lending like drunken bankers: $600,000 zero-down floating-rate loans to single-earner middle-class families buying three-bedroom houses in Vallejo, CA: and we will be sorry.

Christina Wang's paper suggests a second possible explanation. That recent residential investment financed by so-called "non standard" mortgage loans is a result at least in part not of the inebriation of the banking sector but of the ability to more finely calculate risk and return than was possible in the days when your mortgage had to be 30-year-fixed, 20% down, with amortization plus real estate taxes amounting to no more than 33% of last year's household income. That was an inadequate screen. What, really, are the current screens? How good are they? The application of models like this to residential financing may be the real big game here.

On Bloomberg TV today

Bloomberg TV: Programming Schedule: 9/6/2006 2:00 PM ET Bloomberg On the Economy Weekdays, Tom Keene interviews leading economists, politicians and strategists. Longer interviews that go beyond the headlines to provide a depth of economic analysis found nowhere else in the media. Podcast ready, these interviews address the economic news of the moment — and provide context and perspective that is a must-listen in a hurried world. Tom Keene and top economists. It's Bloomberg on the Economy.

http://bloomberg.com/tvradio/podcast/ontheeconomy.xml

China's short-term economic destiny hinges on the health of the American
economy. Of the roughly RMB 20 trillion of value that China will produce
this year, more than ten percent will be exports to the United States. The
United States is the importer of last resort for the Chinese economy: a
sharp fall in demand from America for China's products would stand a very
good chance of sending the Chinese economy into recession. Neither the
Japanese nor Western European governments would allow their imports from
China to rise enough to make up for a substantial fall in demand from the
United States. And the other countries of the world are not rich enough to
be reliable as large-scale sources of demand for exports from China. Thus
China's current export-led development strategy relies, for its short-term
success, on strong demand from America--which requires that America avoid
major recession.

Now, however, for the first time in three years, the possibility of a
major recession in America is on the table.

The United States has a market economy, yes. There are substantial islands
of social democracy within that market economy--total government spending
at all levels of government is roughly one-third of total income, perhaps
one-tenth of the prices in the economy are heavily regulated by government
agencies, and the antitrust authorities act to curb (or attempt to induce
lower prices by threatening to act to curb) monopolies. Yet few would
dispute that the United States has, overwhelmingly, a market economy.

Yet there is an important island of central planning within this market
economy. One of the most key prices in the economy is set by a board of
bureaucrats: the Federal Reserve determines short-term interest rates.
Thus the terms on which businesses and households calculate the relative
price of time and waiting--of producing and consuming next year rather
than this year--is not trusted to the market.

Every month and a half or so, the Federal Reserve's Open Market Committee
meets in Washington. It is a meeting that nearly everyone (except
professional monetary economists) would find mind-numbingly dull. After
the meeting, the Open Market Committee directs the Federal Reserve Bank in
New York to buy or sell short-term Treasury bonds to set the overnight
interest rate on bank reserves. In the case of the last meeting, the Open
Market Committee directed the Federal Reserve Bank of New York to keep the
interest rate on overnight bank reserves at 5.25% per year. Traders
seeking advantage thereupon kept the three-month interest rate on Treasury
bills--short-term bonds--at the same 5.25% per year.

The Open Market Committee decided that this key price--the interest
rate--didn't need to be raised or lowered to be consistent with price
stability and with maximum employment, purchasing power and growth. This
is the first time in two years (and 18 meetings -- the meetings are held
every month and a half) that the FOMC has not raised interest rates, which
have climbed 4.25 percentage points since the spring of 2004.

From one perspective these FOMC decisions are trivial and tiny. As a
result of this phone call, the trading desk at the Federal Reserve Bank
will buy or sell a few extra billion dollars in bonds, far less than $100
worth for each person in the United States. Banks and other financial
institutions will have a little more or less cash, and a little fewer or
more bonds, but the proportion of cash and bonds in their portfolios will
change by what seem to be insignificant amounts.

Yet such relatively small actions by the Federal Reserve's FOMC affect
every single bond price and interest rate in the entire world. Traders on
Wall Street are now revising their expectations about the future path of
interest rates.

When the FOMC raises interest rates, as many expected would happen
Tuesday, corporations tend to borrow a little bit less than they would
have otherwise, spend a little bit less on new factories and equipment,
and so hire fewer people. Construction companies borrow a little bit less,
spend a little bit less building houses, and so hire fewer people. The
slightly higher interest rates lead a few households to decide not to take
out that home equity loan after all. Those households spend less, so the
businesses that supply what they buy hire fewer people.

The chain of decisions triggered by raising interest rates is costly.
Unemployment would be a little bit higher if the FOMC had raised interest
rates today: By November 2007 there would probably be an extra 250,000
Americans unemployed. That's why the FOMC didn't do it. That's why the
FOMC stood pat and kept bond prices and interest rates constant Tuesday.

But raising interest rates would have had benefits as well. Lower demand
lowers inflation. Because the FOMC didn't raise interest rates this time,
by November 2007 inflation will probably be higher by about 0.1 percent
per year. If you believe -- as the FOMC does, with a faith so strong that
St. Paul would marvel at it -- that the economy works much better if
prices are roughly stable, with lower average unemployment and faster
growth, then that creep-up of inflation is not something that should be
allowed to continue indefinitely.

Every economist in the world wishes Federal Reserve chairman Ben Bernanke
and his team at the FOMC well. We all hope that he makes the right
decisions, even when we disagree with him. We would prefer that his
decisions be right and our judgments be wrong rather than his decisions be
wrong and our judgments be right. But we all have our views, and so the
FOMC's meetings every month and a half are surrounded by a chorus of
commentary from economists, each of them saying what he or she thinks the
FOMC should do.

For the Federal Reserve is trying to hit the sweet spot. It would be bad
if inflationary pressures returned to the levels they were in the 1970s,
and growth slowed as people became confused about which prices were rising
because goods were in short supply and which prices were rising simply
because the Federal Reserve had pumped too much cash into the economy by
keeping bond prices too high and interest rates too low. It would be bad
if the Federal Reserve pushed bond prices too low and interest rates too
high and then discovered that it had pushed unemployment higher as well.

Some think that the FOMC has already raised interest rates too high. They
see an economy in which the principal danger is not that inflationary
pressures are gathering but that spending is already falling. Dean Baker
of the Center for Economic and Policy Research notices rapid increases in
credit-card debt outstanding in May and June, and fears that this is a
sign that past FOMC interest rate increases are already shutting down the
home-equity ATM, and that households that can no longer borrow
attractively against home equity are maxing out their credit cards. If
that's true, they will be forced to cut back on the consumer spending that
has fueled so much of the current business cycle expansion. The economy is
still growing now, but Baker and others think that's because a lot of the
consequences of the past two years of interest rate increases have not yet
had their full effect. These increases are still "in the pipeline," and
come November 2007, according to this point of view, we will all be glad
that that the FOMC did not raise interest rates Tuesday.

On the other side, Marty Feldstein of Harvard, president of the National
Bureau of Economic Research, and former chairman of the President's
Council of Economic Advisors under Ronald Reagan, believes that the
Federal Reserve must "convince the markets that inflation will be
contained" as successfully under the stewardship of Bernanke as it was
under Alan Greenspan, and as a result the FOMC "must show that it is
willing to take the risk of tightening [interest rates] too much." But
John Berry (who used to make the Washington Post's coverage of the Federal
Reserve the most sophisticated of all daily newspapers before he jumped to
Bloomberg) judges that the markets expect a pause, and that there will not
"be much of a backlash from analysts wringing their hands about Fed
Chairman Ben S. Bernanke being 'soft on inflation' or about the loss of
Fed credibility as an inflation fighter. After all, a pause would be just
that."

Feldstein recognizes that uncertainty is immense, and that he could well
be wrong in his judgment that inflationary pressures are the major risk to
be guarded against: "The consequences of the past [two years' worth of]
interest rate hikes are difficult to predict ... [a] fall in house prices;
residential construction plummet[ing] …; lower housing wealth; [a] sharp
fall in mortgage refinancing, bringing down consumer spending,
expenditures on equipment and software slow[ing] sharply … A much sharper
slowdown than the central tendency forecasts is certainly possible."

This uncertainty is the reason that the FOMC is feeling its way month by
month, moving interest rates in small, bite-sized quarter-percent
increments, and warning everyone that it does not know what it is going to
do next. The FOMC calls its decisions "data dependent," and the committee
members know the stakes and risk and the magnitude of uncertainty as well
as anyone.

From one perspective this looks like witchcraft: a group of people in a
room pulling and pushing metaphorical levers when they are not sure how
strongly these levers are attached to anything.

From another perspective this is a triumph of technocratic central
planning. Trained professionals are trying their best to socially engineer
a healthy and productive economy. They're thinking and making decisions at
a level of detail and sophistication that not one person in a thousand can
follow, and yet those decisions have a powerful impact on all of us.

And it is not only the short-term economic destiny of the United States
that hinges on whether the FOMC has gotten it right. The short-term
destiny of China, and of the rest of the world, hinges on the FOMC's
getting it right as well.

The pause that might not refresh: Tuesday, for the first time in two years, the Federal Reserve didn't raise interest rates -- but is the damage already done?

<http://www.salon.com/opinion/feature/2006/08/08/interest_rates/print.html>

By Brad DeLong

Aug. 08, 2006 | Shortly before 2:15 p.m. Eastern time Tuesday, after a meeting in Washington that nearly every American would've found mind-numbingly dull, someone made a phone call to the Federal Reserve Bank in New York. The purpose of the phone call was to tell the bank's trading desk that the Federal Reserve's Federal Open Market Committee, known as the FOMC, had decided that the level of bond prices -- specifically, the price of three-month Treasury bills: promises by the U.S. Treasury to pay cash in three months -- was just right.

The price didn't need to be raised or lowered to be consistent with price stability and with maximum employment, purchasing power and growth. The FOMC told the trading desk to buy and sell some of its three-month Treasury bills to keep their price stable, and thus keep the interest rate the Treasury bills would earn stable: 5.25 percent. This is the first time in two years (and 18 meetings -- the meetings are held every month and a half) that the FOMC has not raised interest rates, which have climbed 4.25 percentage points since the spring of 2004.

From one perspective these FOMC decisions are trivial and tiny. As a result of this phone call, the trading desk at the Federal Reserve Bank will buy or sell a few extra billion dollars in bonds, far less than $100 worth for each person in the United States. Banks and other financial institutions will have a little more or less cash, and a little fewer or more bonds, but the proportion of cash and bonds in their portfolios will change by what seem to be insignificant amounts.

Yet such relatively small actions by the Federal Reserve's FOMC affect every single bond price and interest rate in the entire world. Traders on Wall Street are now revising their expectations about the future path of interest rates.

When the FOMC raises interest rates, as many expected would happen Tuesday, corporations tend to borrow a little bit less than they would have otherwise, spend a little bit less on new factories and equipment, and so hire fewer people. Construction companies borrow a little bit less, spend a little bit less building houses, and so hire fewer people. The slightly higher interest rates lead a few households to decide not to take out that home equity loan after all. Those households spend less, so the businesses that supply what they buy hire fewer people.

The chain of decisions triggered by raising interest rates is costly. Unemployment would be a little bit higher if the FOMC had raised interest rates today: By November 2007 there would probably be an extra 250,000 Americans unemployed. That's why the FOMC didn't do it. That's why the FOMC stood pat and kept bond prices and interest rates constant Tuesday.

But raising interest rates would have had benefits as well. Lower demand lowers inflation. Because the FOMC didn't raise interest rates this time, by November 2007 inflation will probably be higher by about 0.1 percent per year. If you believe -- as the FOMC does, with a faith so strong that St. Paul would marvel at it -- that the economy works much better if prices are roughly stable, with lower average unemployment and faster growth, then that creep-up of inflation is not something that should be allowed to continue indefinitely.

Every economist in the world wishes Federal Reserve chairman Ben Bernanke and his team at the FOMC well. We all hope that he makes the right decisions, even when we disagree with him. We would prefer that his decisions be right and our judgments be wrong rather than his decisions be wrong and our judgments be right. But we all have our views, and so the FOMC's meetings every month and a half are surrounded by a chorus of commentary from economists, each of them saying what he or she thinks the FOMC should do.

For the Federal Reserve is trying to hit the sweet spot. It would be bad if inflationary pressures returned to the levels they were in the 1970s, and growth slowed as people became confused about which prices were rising because goods were in short supply and which prices were rising simply because the Federal Reserve had pumped too much cash into the economy by keeping bond prices too high and interest rates too low. It would be bad if the Federal Reserve pushed bond prices too low and interest rates too high and then discovered that it had pushed unemployment higher as well.

Some think that the FOMC has already raised interest rates too high. They see an economy in which the principal danger is not that inflationary pressures are gathering but that spending is already falling. Dean Baker of the Center for Economic and Policy Research notices rapid increases in credit-card debt outstanding in May and June, and fears that this is a sign that past FOMC interest rate increases are already shutting down the home-equity ATM, and that households that can no longer borrow attractively against home equity are maxing out their credit cards. If that's true, they will be forced to cut back on the consumer spending that has fueled so much of the current business cycle expansion. The economy is still growing now, but Baker and others think that's because a lot of the consequences of the past two years of interest rate increases have not yet had their full effect. These increases are still "in the pipeline," and come November 2007, according to this point of view, we will all be glad that that the FOMC did not raise interest rates Tuesday.

On the other side, Marty Feldstein of Harvard, president of the National Bureau of Economic Research, and former chairman of the President's Council of Economic Advisors under Ronald Reagan, believes that the Federal Reserve must "convince the markets that inflation will be contained" as successfully under the stewardship of Bernanke as it was under Alan Greenspan, and as a result the FOMC "must show that it is willing to take the risk of tightening [interest rates] too much." But John Berry (who used to make the Washington Post's coverage of the Federal Reserve the most sophisticated of all daily newspapers before he jumped to Bloomberg) judges that the markets expect a pause, and that there will not "be much of a backlash from analysts wringing their hands about Fed Chairman Ben S. Bernanke being 'soft on inflation' or about the loss of Fed credibility as an inflation fighter. After all, a pause would be just that."

Feldstein recognizes that uncertainty is immense, and that he could well be wrong in his judgment that inflationary pressures are the major risk to be guarded against: "The consequences of the past [two years' worth of] interest rate hikes are difficult to predict ... [a] fall in house prices; residential construction plummet[ing] …; lower housing wealth; [a] sharp fall in mortgage refinancing, bringing down consumer spending, expenditures on equipment and software slow[ing] sharply … A much sharper slowdown than the central tendency forecasts is certainly possible."

This uncertainty is the reason that the FOMC is feeling its way month by month, moving interest rates in small, bite-sized quarter-percent increments, and warning everyone that it does not know what it is going to do next. The FOMC calls its decisions "data dependent," and the committee members know the stakes and risk and the magnitude of uncertainty as well as anyone.

From one perspective this looks like witchcraft: a group of people in a room pulling and pushing metaphorical levers when they are not sure how strongly these levers are attached to anything.

From another perspective this is a triumph of technocracy. Trained professionals are trying their best to socially engineer a healthy and productive economy. They're thinking and making decisions at a level of detail and sophistication that not one person in a thousand can follow, and yet those decisions have a powerful impact on all of us.

-- By Brad DeLong

The Odds of Economic Meltdown: With interest rates and oil prices rising and consumers spending beyond their means, we may be headed for recession -- and worse.

Brad DeLong

<http://www.salon.com/opinion/feature/2006/08/03/recession/>

Aug. 3, 2006 | Forecasting recessions is a fool's game. If there is enough solid economic information to make it appear highly likely that a recession is coming -- that production, unemployment and consumer demand will actually fall -- then it is highly likely that there already is a recession. Businesses are not stupid, and they don't have to wait for economists to tell them what they already know. By the time a gloomy forecast has been issued they've probably already noticed a drop in consumer demand and responded by firing workers and reducing production.

So: Never say that a recession is coming. Say only that a recession is here, or that there might be a recession on the way. Which, in fact, is what I'm saying today. As of the beginning of August 2006, a recession is not here, and I'm not going to violate my own rule by saying one is coming. But there is a good chance -- for the first time since 2003 -- that there might be a recession in progress six months from now.
Why? Three factors: 1) A Federal Reserve that finds itself with less inflation-fighting credibility than it thought it had; 2) upward pressure on inflation from rising energy and, perhaps, import prices; and 3) millions of middle-class homeowners who for too long have treated their houses as gigantic ATMs, using home equity loans and refinancing to generate extra spending money.

First, the Federal Reserve, now chaired by Bush appointee Ben Bernanke. The Federal Reserve sets interest rates, and when it does it tries to hit the economy's sweet spot: that point that produces maximum employment, purchasing power and growth without generating enough upward pressure on prices to produce expectations of inflation. The Federal Reserve does this by pushing interest rates up and down. Push interest rates up and businesses find it more expensive to expand capacity and production, causing them to cut back on investment spending. Push interest rates up and households' balance sheets deteriorate, causing them to cut back on consumption spending. Push interest rates down and firms find it cheaper to expand capacity and production, and so they ramp up investment spending. Push interest rates down and households find their balance sheets looking better and feel flush, expanding consumption spending.

There is one major complication: what Milton Friedman calls the "long and variable lags" in the system. Every action the Federal Reserve takes now affects production, demand and inflation roughly 15 months in the future. What the Federal Reserve has done in the past 15 months has not yet had a chance to affect the economy.

This leads to the Federal Reserve's current dilemma. The last two percentage points' worth of increases in interest rates -- increases in interest rates that will in the end make businesses cut back on investment spending and households feel pinched -- have not yet had a chance to affect the economy. Because of "long and variable lags," they are still "in the pipeline." When they emerge from the pipeline they will slow the economy further. By how much? Nobody is really sure.

In this situation it seems reasonable that the Federal Reserve should stop raising interest rates. Waiting to see what the interest-rate increases of the past couple of years will do to the economy would be a prudent strategy. Indeed, since last December the Federal Reserve has been quietly signaling that it is about to "pause," to adopt such a wait-and-see strategy. Yet so far it has not done so. Why not? One important reason is that the Federal Reserve is scared that if it pauses too soon it will convince many observers that it is not truly serious about fighting inflation -- and a central bank has a hard time fighting inflation if businesses, speculators and workers ever conclude that it is not truly serious.

The Federal Reserve is also unwilling to stop increasing interest rates because it is afraid of recession risk factor No. 2: a rise in oil and import prices. Those fears are justified. Remember how the invasion of Iraq, besides bringing a golden age of democracy to the Middle East, was also supposed to produce $15-dollar-per-barrel oil? Oil is now at $75 a barrel, and this rise in oil prices is putting upward pressure on prices in general. As for import prices, they are vulnerable to a U.S. dollar that has been weakened by the Bush budget deficit and massive borrowing from China. Suppose the dollar declines suddenly, which is not a far-fetched possibility. Should the dollar fall by, say, 30 percent, and should importers raise their dollar prices in proportion, then the one-sixth of U.S. spending that is spending on imports will see prices rise by 30 percent. Because 30 percent times one-sixth equals 5 percent, that would boost U.S. consumer prices by 5 percent nearly overnight.

Thus there are two big reasons for the Federal Reserve to keep raising interest rates, in spite of how much downward pressure on demand is still in the pipeline. The Federal Reserve thinks it needs to do so in order to establish its long-term credibility, and there are the twin dangers of oil- and import price-triggered inflation to guard against.

Most likely the Federal Reserve's continued raises in interest rates will not send the economy into recession. But there is that chance, and the chance is raised from a low-probability possibility to a serious worry by the third factor: that home-as-ATM problem. The unprecedented use of home loans to squeeze cash out of equity has allowed middle-class consumers to spend well beyond their means. Someday this spending spree has to come to an end. If it comes to an end suddenly, at a time when the Federal Reserve has raised interest rates a little too much, then we have our recession.

Make no mistake about it: The U.S. economy is close to the edge. Retail sales in the second quarter were rising at only a 2.1 percent annual pace. Business investment in equipment and software was falling. Residential construction was falling. Either households will continue spending beyond all reason, or businesses will start boosting investment, or exports will start booming, or there will be a recession sometime in the next year. Figure the odds at 3 out of 10.

What can be done to head off the danger? Unfortunately, very little. The bag of macroeconomic tricks is empty. In 2000-2001 the Federal Reserve could lower interest rates to the floor, boosting residential construction and consumer spending to offset the decline in high-tech investment, and turn the 2001 recession into a very small event indeed. In 2002-2003 the short-run stimulative effect of the Bush tax cuts came online at exactly the right moment to offset fears of a deflationary spiral. But today further fiscal stimulus would increase global imbalances -- meaning, raise the trade deficit -- and do more damage to confidence than it might do good in curing a recession. And sharp reductions in interest rates would lower the value of the dollar and increase inflationary pressures from import prices in a way that the Federal Reserve does not dare allow.

The past 24 years have been an amazing run as far as the business cycle is concerned. There have been only two recessions, and both of those were short and shallow. But Ben Bernanke and Co. are now at real risk of presiding over the third.

A Primer on the Federal Reserve: what it does and why: