3 posts tagged “monetary policy”

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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.