My friend and former colleague (and our occasional commenter), James Kahn, weighs in on Federal Reserve policy in a thoughtful piece over at Fox Business.
Some highlights:
Proponents of the Fed’s ZIRP (zero-interest rate policy) will quickly point out that the low inflation numbers in recent years belie any claim that policy has been too loose. In a sense they are right: Policy has not been as loose as interest rates suggest, because the Fed has been pushing forward on one lever (asset purchases) while pulling back on another (paying interest on bank reserves). With the economy’s mediocre fundamentals (those supply factors mentioned above), banks are happy to hold large reserves of cash, thus blunting the impact of the Fed’s enormous balance sheet increase.
Bernanke’s gloating about the lack of inflation is thus somewhat misplaced. The concern about losing control of inflation (in one direction or the other), has always been (or should have been), on the Fed’s ability to manage the transition back to normalcy, i.e. the unwinding of its balance sheet, the raising of interest rates, and the drawing down of bank reserves. The Fed may be able to manage all this, but so far it is just lots of rhetoric – it brags about the ability to do so while postponing actually doing it.
In other words, thoughtful critics have said all along that there’s an inflation risk associated with the (future) transition back to normal monetary policy. Less thoughtful counter-critics have claimed to refute that observation with the counter-observation that right now, inflation doesn’t seem to be a problem. Like the optimist in free fall, they figure we’re doing alright so far.
Another highlight:
Predicting the future course of the economy, especially around turning points, is notoriously difficult. [The point] is to urge the Fed to show more humility, to know what it does not know. There is a recurring pattern of hubris: policy decisions that presume unwarranted confidence in both the direction of the economy and in the Fed’s ability to manage through unforeseen changes. The broader lesson is that the Fed has not demonstrated the ability to micro-manage business cycles.
But there’s much more. Go read the whole thing.
(The following should be considered barroom opinion, not a scholarly conclusion)
As with (for example) Ricardian equivalence, actors act so as to account for the known future. Much of the Fed’s ability to manage the transition is based on making actors act in ways they otherwise would not (in the absence of a Fed policy). As such it is reliant at least in part on the ability of the Fed to act in ways which are not expected. The more light is shone on the Fed’s actions by academics and bank research economists, the better understood they are, the more predictable they become, and potentially the less effective they may be.
In a similar way, the risk premium disappeared as soon as academics explained it, and bank wizards worked out how to hedge it, and so bid the risk premium down to the cost of implementing the hedging algorithm.
The mechanism of control fails once it is widely understood. The surprise has to be that it took so long to occur.
Ben I think you touch on the basic debate over whether monetary policy has to “fool” people and even devolve to “randomness”, or will always have real impacts due to “bounded” or “near” rationality.
But even if it has real effects are there limits to the benefits? Everyone is learning as we go and we can never prove negatives but at this point it does seem harder to make the case that the economy wouldn’t have done at least as well had policymakers done less (some TARP was probably prudent to prevent an all-out banking panic). It doesn’t seem that surprising that the cost of smoothing at any cost is a more extended and sluggish recovery. The argument here (and increasingly elsewhere) further suggests that sustained zero rates can create their own sort of “trap” (it would seem advocates of “hysteresis” phenomena might be inclined to give that notion due consideration).
The key to the decision about stopping ZIRP is the asymmetry of risk (Krugman).
If the Fed raises rates too late, there will be some additional inflation. That is not a big deal.
If the Fed raises rates too soon, it could trigger a deflationary recession. That is a very big deal (just look at what happened in Sweden).
Given this huge asymmetry in risk, I don’t think that there is a defensible case for a rate hike. And I agree with Paul McCulley, who said that the opposition against the Fed’s ZIRP was driven not so much by economic arguments, but by a kind of moral outrage. He said that to many people, the ZIRP was “the moral equivalent of a fat man in Speedos”. Just wrong. You can’t really say why it’s wrong (the arguments have kept being disproven and replaced by new ones), it’s JUST WRONG.
In the article, Kahn also makes a fallacious point.
He states that the last recession was deeper than usual, so he argues that the recovery should have been better as well.
That is just wrong. The last recession wasn’t a “normal” recession, it was triggered by the bursting of a massive credit bubble, which inflicted huge damage on the US financial system. This kind of event is generally followed by prolonged periods of sub-par growth. By now, this fact should be known to anyone remotely interested in economics.
But what I find really inexplicable is the idea that because the Fed doesn’t know the perfect timing to raise rates, so it should do it now. Given the risks involved in raising rates too early, that’s exactly wrong. Given the uncertainty of the right timing, you need to wait EXTRA LONG.
And what is this gobbledygook: “As in Japan, where more than a decade of zero interest rates and fiscal stimulus failed to restore anything like normal growth, the U.S. economy would likely be better off now had both monetary and fiscal policy reverted to neutral and instead allowed the economy’s natural restorative forces unleash themselves.”
“Allowing the economy’s natural restorative forces to unleash themselves”? What the hell is that supposed to mean?
Is this Mellon-style liquidationism? Austerity + interest rate hikes to “purge the rottenness out of the system”?
The Swedes raised their interest rates in 2010/2011. The result was a plunge into deflation and recession. Why on earth would the US want to follow their example?
And Krugman says the problem is a “lack of aggregate demand,” which seems equivalent to saying the reason we don’t have enough water flowing through the system is because we don’t have enough water pressure, or the reason we aren’t going fast enough is because the MPH shown on our speedometer isn’t high enough.
Economists – PK in particular – are always going on about “growth,” but when I look at the charts I’m seeing GDP. I’d suggest that “growth” means an increase in both capacity to produce X and demand to consume X. Increased demand without increased capacity is “inflation” – a bubble. As GDP only measures the relative value of demand, it can’t distinguish between true growth and bubbles.
Given only GDP, I think it’s reasonable to conclude that policies that reduce GDP will also reduce growth. However, you simply can’t assume that therefore any policy that increases GDP will also increase growth. This is the error that PK makes again and again, in my opinion.
On the other side, though, that doesn’t mean he’s “wrong” when he says the Fed should keep the interest rates at 0 – the answer is just incomplete, and Kahn’s position seems equally incomplete.
Of course, he’s a Nobel prize winner – so maybe I’m missing something. Prof. Landsburg, I’d love to hear your thoughts.
@Advo #3, yesterday Krugman posted a link to an interview on Business Insider with Stanley Druckenmiller to mock him as a doomsayer. I listened to the interview, though, and whether he’s right or wrong Druckenmiller suggests that there more risks than simply the potential for inflation.
Druckenmiller agrees the Fed’s actions were necessary and appropriate at the time (2008) but if I understand correctly I believe he’s suggesting that as the current policies go on they create distortions in the economic system that could have long-term repercussions beyond just the potential for inflation. For example, in this environment companies tend to borrow money for stock buy-backs, rather than investing in R&D and growth.
Perhaps Kahn is speaking at a level of sophistication that only his fellow economists can follow. But it’s gobbledygook to me.
And we should judge this recovery relative to US recoveries from different recessions, rather than relative to how other economies are recovering from this recession, because…?
Bernanke observes that nations that have adopted Kahn’s proposed policies have fared less well than the US. Why isn’t that the relevant comparison?
In other words, because the last recession was so deep, we would desire an even faster recovery than in prior recessions. And we should evaluate policy relative to our desires, rather than relative to other plausible policies, because…?
Is Kahn suggesting that the entire world of potential borrowers/lenders – or some market-dominating share of them – has conspired to coordinate their actions to postpone otherwise mutually desirable transactions for the purpose of manipulating the Fed into keeping interest rates low?
As far as I can tell, the only panic that ensues from the hint of an interest rate hike is the reaction of individual businessmen that a hike might depress the economy, undermining the assumptions that underlie their business plans. It seems only rational that businessmen would have such concerns, and that the Fed would take those reactions into account.
So higher interest rates and less stimulus would have helped the Japanese economy … how? Yeah, it would have attracted more capital from abroad, and converted some domestic consumption to investment. But is there any evidence that Japan is suffering for a lack of liquidity, or from excessive consumption?
I’m in Advo’s camp.
“[T]hose supply factors mentioned above”? WHAT supply factors mentioned above?
And if banks had cause to fear inflation, why would they hold onto large reserves of cash? I’d guess that they hang onto cash because their inflation fears are subordinated to their fears of lending money to people who won’t be able to repay it due to a struggling economy (or, rephrased, the bank’s own desire to maintain liquidity in the face of economic uncertainty). In other words, inflation is the subordinate concern.
Truly, nobody.really can ever forget such a remark.
So forecasting is an imperfect business, and forecasters should exhibit humility — and therefore Kahn can confidently predict that increasing interest rates would produce better results because…?
I’ll concede that we should not discount long-term consequences (those $ 3 trillion on the Fed’s books) as we evaluate the status quo level of inflation. But if there are big advantages to raising interest rates in the current environment, I don’t see them. For example, how would higher interest rates cause firms to shift from buying back stock to investing in R&D?
A side issue:
When does a recession begin?
One definition of recession is a decline in GDP for two consecutive quarters. Does the recession begin when the data arrives about GDP after the second quarter? Or at the conclusion of that quarter? Or at the beginning of the first quarter – when, by definition, it would be impossible to detect?
And if we adopt this last concept for when a recession begins, why would anyone be surprised that the Fed did not adopt appropriate reactive policies until well after the recession began?
@nobody.really, I think the key question is if there’s such a thing as a “normal” or “ideal” Fed funds rate. Seems reasonable to think that there could be such a thing – that if there’s an ideal rate of growth, with a corresponding ideal inflation rate, that there ought to be a corresponding ideal Fed funds rate.
If that’s true, then there may be relative / short term disadvantages to raising the rate, but there could simultaneously be absolute / long term advantages to restoring the rate to the “ideal” level. Given that, the question isn’t just whether all things being equal we’d want to raise the rate, it’s whether the benefit of restoring the ideal rate outweighs the harm of raising the rate.
Could very well be that right now it doesn’t – but presumably there is a point at which it will.
BTW I’d note that raising the Fed funds rate will only “raise interest rates” to the extent that it’s the constraint on rates – it’s not the only factor, though.
One of the risks with transition to so-called normal policy is deflation. Good example is the ECB. The ECB has raised the interest rates in 2011. The ECB has drawn down bank reserves in 2011 and 2014. The ECB has sharply reduced its balance sheet in 2013 and 2014. All these moves were reversed by the ECB as deflationary pressures intensified in response.
“The Fed has been pushing forward on one lever (asset purchases) while pulling back on another (paying interest on bank reserves).”
At the moment the ECB is pulling both levers in the same direction – it is doing QE while paying negative rates on reserves. Even though interest rate on reserves is positive in US and negative in the Eurozone, we do not observe higher inflationary risks in the Eurozone.
@Steve S. from CT
The “ideal” Fed funds rate differs depending on the circumstances. Under conventional macroeconomic theory, the ideal rate is that rate which achieves full employment without exceeding the inflation target to the upside – and, I might add, without creating a danger of falling into deflation. The CPI is currently 0%. The Core CPI (without food and energy) is 1.9% – with no visible uptrend over recent several years. Consumer inflation expectations have been falling since 2011 and are now at the lowest level since 2010.
Wage pressures are still minimal.
The idea that in such a situation inflation could suddenly accelerate wildly is, to put it mildly, not supported by economic theory or empirical experience.
The more I read the Kahn article, the less coherent it seems. Does Kahn actually make any kind structured economic argument? If so, what is it supposed to be?
Conventional macroeconomic theory tells us that tightening monetary policy will decrease economic activity. Yet Kahn apparently suggests that the opposite is true, without spelling out any reasoning why that would be the case.
Extraordinary claims require extraordinary support. Kahn offers neither economic arguments nor empirical evidence for his ideas, and how could he. Of all the countries hit by the bubble, the US appears to have done best. Countries which tightened monetary policy (i.e. Sweden and the EU) did worse, precisely as economic theory would predict.
Prof. Landesburg has in the past excoriated Krugman for deficiencies in the economic reasoning of his articles.
Kahn’s article doesn’t actually seem to contain any economic reasoning, certainly not enough to support ideas which contradict basic tenets of macroeconomics.
…K A H N …. !!!
Going a bit off-topic: In the long run, should we expect interest rates to tend to rise, fall, or be uncorrelated with the past?
Imagine that the world is awash in more wealth, including liquid wealth, than Milton Friedman could have ever dreamed. Wealthy people seek out places to find good (risk-adjusted) returns. And when those are all exploited, they look for adequate returns. And when those are all exploited, they look for meager returns. Hell, they become so desperate that they invest in novel sub-prime mortgage securities and the like.
In short, I would expect risk-adjusted returns to fall. And fall and fall. Sure, occasionally there would be a new innovation that would trigger a new demand for capital. (Women in the workforce! The internet! Lunar real estate!). But the long-term trend would be down.
This thesis is built on the premise that the supply of wealth will grow faster than the demand. Admittedly, this has not been the historical pattern. Thus, someday this thesis may read like the forecast “There is no conceivable reason a person would want a computer in his home.”
But the alternative thesis would seem to defy the pattern of diminishing marginal returns. By conventional measures, the world is growing richer, even on a per-capita basis. To suggest that the world should continue to expect returns that are on average equal to or greater than past returns would imply that our past efforts to prioritize high-return activities have been wholly ineffective – that we’ve been basically investing at random.
Which thesis seems less plausible?
I believe that diminishing risk-adjusted returns are to a large degree caused by deteriorating demographics in the developed world (and in China, of course).
Deteriorating demographics are what accounts for Japan’s deflationary equilibrium. Japan’s working age population started to decline in the mid-1990s and is now down by about 10% from its peak. It is currently declining by approx. 1.3% p.a.
This reduces expected future demand, which decreases business investment, which decreases productivity growth, and all of this together reduces RoC.
The result is that the natural interest rate in Japan is negative. There are essentially two possible policy responses to this: boost demand by continuously creating permanent, free money which is made available for consumption without creating liabilities (Friedman called it “helicopter money”) or boost demand through permanent government deficits which create enormous amounts of debt. The economic effects of both options are very similar, except that with the second option, the government eventually has to default on its debt one way or the other.
Europe, by the way, recently also started to go into demographic decline, though it’s thankfully a much slower downtrend than in Japan.
If this recession can’t be compared to previous ones, and the Fed is doing things is has never done before, perhaps a “traditional” analysis of monetary policy isn’t the end of the story either? I’m going to go ahead and assume a former Fed VP passed econ 101. Anytime we distort market signals this much for this long we should certainly be thinking about second-order consequences. E.g. an artificially flat curve incentivizes borrowing but not necessarily investing. But Keynesianism’s strong suit was never on the longer-term effects. There’s a growing sense that the Fed is no longer data-dependent but asset-price dependent, which can indeed be a trap.
BTW on what the hell “natural restorative forces” means – even Keynes believed market economies self-correct, eventually (different mechanisms for that – falling prices boost real incomes, inventories must be replenished, confidence returns…there’s a reason they’re called cycles, and we still don’t understand them very well). Again at this point it’s unclear at best whether we wouldn’t have recovered at least as quickly “naturally” (is less stimulus what is meant by “austerity”?), and with much less debt overhang. Responding to a credit bubble by encouraging more of the same behaviors that generated the bubble does not seem conducive to corrective adjustments, but rather a more prolonged and sluggish (if somewhat smoothed) recovery. At least the wise regulators will make sure certain mistakes are not repeated.
@ Iceman,
How has the federal reserve distorted economic incentives exactly? I often here this claim with little evidence to back up the statement. In what way is the federal reserve no longer data-dependent? Have we seen inflation over 2%? Nope: http://data.bls.gov/timeseries/CUUR0000SA0L1E?output_view=pct_12mths
Has U-6 unemployment returned to its normal pre-recession rate? Getting there but still a ways to go:
http://data.bls.gov/timeseries/LNS13327709
When you say that the federal reserve is asset driven, have you any proof for this? Seems to me that they are waiting until the data actually return to normal before pulling back on growth levers. To suggest that the federal reserve cares about the price of assets is to not know anything about the way the federal reserve actually works.
The best we can do is a dif-in-dif since this recession (unlike the past couple which were caused by the federal reserve to pull down inflation while this was a financial crisis) and what we see is that countries in this recession that pulled back on monetary policy, which spent less in stimulus have done worse. In your theory of the world less stimulus should mean greater growth, it hasn’t. Explain to me why only through austerity, not less stimulus should we see greater increases in growth than more stimulus? Your argument practically crumbles on this point.
@Iceman,
a post-credit bubble recession is different in that it is deeper and the recovery process is way slower than usual.
It is not different in the sense that the laws of gravity are flipped upside-down.
Stimulative monetary and fiscal policies are still stimulative; contractionary policy is still contractionary.
This is very evident from empirical experience, and then of course no one has come up with a plausible economic argument why this shouldn’t be the case.
The only thing you get by way of intellectual support for the moral outrage against ZIRP is gobbledygook like in Kahn’s article.
“In other words, thoughtful critics have said all along that there’s an inflation risk associated with the (future) transition back to normal monetary policy. Less thoughtful counter-critics have claimed to refute that observation with the counter-observation that right now, inflation doesn’t seem to be a problem. Like the optimist in free fall, they figure we’re doing alright so far.”
Haha, classic Landsburg misdirection, saying only people on his side are thoughtful about such things. One person says current fed policy puts us at risk for inflation, another person says inflation is only a risk once we have cleared slack in the labor market. The fed listens to the second person and we do not observe an increase in inflation. The first person’s hypothesis is not testable since he only says we are at some point at risk for inflation, not giving any indication of what conditions we must meet for our risk of inflation to turn to actual inflation. Now landsburg is saying that the thoughtful person is the one who’s hypothesis is not testable rather than the one that’s hypothesis is not only testable but supported by the data. I suggest that Landsburg goes back to high school to learn the basic premise of making testable hypothesis before making meaningless proclamations on who is and is not thoughtful.
@Iceman, the Fed has distorted market signals continuously for as long as it has existed. Indeed, that is basically the whole point for its existence.
Another good reason for ignoring the “we should be comparing to other recessions instead of other countries thing” is that this time the rest of the world is doing especially bad at pulling itself out from the doldrums. The biggest western problem being the Euro of course (countries feeling tied together fiscally with no clear joint responsibility for their fiscal situation) leads to less spending overall and even less spending in areas of Europe least employed (Portugal, Ireland, Greece, Spain). They then export some of their drag here as a stronger greenback translates into higher trade deficits. I suspect that had it not been for the perpetual Euro issues of the past 5-7 years we’d have been much closer to full recovery by now.
I just want to respond to some of the comments here, which I appreciate, even the really negative ones. Sorry I don’t have time to address all of them point by point.
1. “The key to the decision about stopping ZIRP is the asymmetry of risk (Krugman).
If the Fed raises rates too late, there will be some additional inflation. That is not a big deal.
If the Fed raises rates too soon, it could trigger a deflationary recession. That is a very big deal (just look at what happened in Sweden).”
These assertions have no support other than appeal to authority (Krugman). Additional inflation can be a big deal because the Fed has rarely been able to get inflation back down again without causing a recession. In fact, there is a strong case to be made that the Fed leaving rates so low in 2003-4 helped fuel the bubble that led to the Great Recession.
As for raising rates causing a recession, that has only happened when rates have been raised so much as to invert the yield curve.
2. “The last recession wasn’t a “normal” recession, it was triggered by the bursting of a massive credit bubble, which inflicted huge damage on the US financial system. This kind of event is generally followed by prolonged periods of sub-par growth. By now, this fact should be known to anyone remotely interested in economics.”
There are many economists who argue this, but it is hardly a law of nature. The U.S. has experienced rapid recovery from financial crises, notably in the early 20s, and even in the Great Depression, when the economy roared back between 1933 and 1937. This is another version of the untestable “It would have been even worse without the Fed” argument.
3. “Conventional macroeconomic theory tells us that tightening monetary policy will decrease economic activity. Yet Kahn apparently suggests that the opposite is true, without spelling out any reasoning why that would be the case.”
Conventional macroeconomic theory actually says that the Fed has only a transitory impact on the real economic activity. Keeping rates near zero has thus likely had little real impact since the early years of the recovery. (Hence my statement, “The reality is that the Fed years ago exhausted the potential of monetary policy to do anything other than prop up asset prices.”) But in any case, I did not say that raising rates would boost growth. In fact I said that raising rates will cause some pain, but more so the longer it is put off, as we learned from 2003-4.
4. “So forecasting is an imperfect business, and forecasters should exhibit humility — and therefore Kahn can confidently predict that increasing interest rates would produce better results because…?”
My point was that uncertainty should cause one to adopt a more neutral stance. The Fed has a history of continuing an aggressive policy (in either direction) based on not foreseeing a turning point, only to find that the turning point had already past. This occurred in 2000, 2004, 2008, for example.
5. “And we should judge this recovery relative to US recoveries from different recessions, rather than relative to how other economies are recovering from this recession, because…?”
The US has generally outperformed Europe for 50 years. The US economy is more like the US of 10 or 15 years ago than it is like the European economy. Saying we’ve outperformed Europe in this recovery is not terribly informative. The fact is that the only recession that did not have a recovery that brought the economy essentially back to the old trend within a few years was 1973, and that happened to coincide with a big productivity slowdown that lasted some 25 years.
6. “And if banks had cause to fear inflation, why would they hold onto large reserves of cash?”
Right now they are getting an interest rate that exceeds the rate on short-term T-bills. Why shouldn’t they hold onto large reserves? It’s risk-free income. If inflation increases or if other rates increase, they can dump those reserves very quickly. There’s very little inflation risk from holding those reserves because they are completely liquid.
Thanks again for the comments, and I’d suggest not accepting everything Krugman says about the Fed as Truth from on high.
@ James Kahn,
“These assertions have no support other than appeal to authority (Krugman). Additional inflation can be a big deal because the Fed has rarely been able to get inflation back down again without causing a recession. In fact, there is a strong case to be made that the Fed leaving rates so low in 2003-4 helped fuel the bubble that led to the Great Recession.
As for raising rates causing a recession, that has only happened when rates have been raised so much as to invert the yield curve.”
So let me get this straight, better to cause a recession now when we might dip into deflation rather than wait for a recession when we’re at full employment and have some inflationary level above 2% and can handle the downturn? This makes perfect sense! Are you trying to argue that deflation is not really a problem or that the recession will have to be worse if inflation is higher? I do not know what you mean “accepting everything Krugman says about the Fed as Truth”. How about the plurality of experts in economics:
http://www.igmchicago.org/igm-economic-experts-panel/poll-results?SurveyID=SV_4Mgzm4jIDpiQBHT
Oh wait, they’re all subtlety under His control aren’t they?
I’m not going to get into an extended dialogue with someone who thinks snark substitutes for substance, and for actually reading what someone says. But you seemed to have missed this: “As for raising rates causing a recession, that has only happened when rates have been raised so much as to invert the yield curve.”
So no, I don’t think raising rates 25 or 50 basis points, or even 100 basis points, is going to cause a recession. Doing so now rather than waiting until inflation or other symptoms of overexpansion occur is a better bet for avoiding recession.
@James Kahn
Thank you for your response.
A couple of points:
1. “The U.S. has experienced rapid recovery from financial crises, notably in the early 20s, and even in the Great Depression, when the economy roared back between 1933 and 1937.”
The financial crisis in the early 20s wasn’t caused by a monster credit bubble driven by asset speculation which substantially damaged the financial system (except in Florida).
As such, it isn’t comparable to the Great Depression or the Great Recession.
As for the Great Depression – the recovery from 1933 to 1937 is an argument for my case. In 1937, 8 years after the crisis began, real GDP was STILL below pre-crisis levels and unemployment was at around 10%. Even if the Fed and Roosevelt hadn’t conspired to bring about the 1938 recession, it would have taken another few years to get the economy back to “normal”. By any measure, the recovery from the Great Depression was long and protracted.
I know that other countries have sometimes recovered faster from banking crises – but that tends to involve a huge drop in the currency, boosting the economy and a burst of inflation alleviating a lot of the bad debt problem. This is not available to the US or Europe.
2. You’re right that an increase of 25 or 50 basis points will not cause a recession by itself – but it may if it causes the market to expect further tightening.
And hiking rates combats inflation by slowing down economic activity. I don’t think hiking rates by 25 or 50 basis points is going to have a large slowing effect (on its) own, unless it really shifts expectations. But then it won’t have a significant effect on inflation either, right? So why do it?
If you want to hike rates, you’re effectively saying that economic growth is too strong and that there is too much wage pressure. Is that the case? Wages are not even close to achieving productivity growth + core CPI.
Is it the responsibility of the Fed to ensure that wage growth never gets to that stage? From what I read and see, it seems to have become the mindset of many economists that you absolutely have crack down on any signs of sustained real wage growth. Is that really a good long-term policy approach? Is this maybe one of the reasons why real wages haven’t risen in decades?
3. As to the asymmetry of risk – let me ask you the following question: if you compare the two following two scenarios, how much excessive inflation are we likely to get?
Scenario 1: Start hiking now, go to 2% by the end of next year.
Scenario 2: Do nothing for 8 months unless some concrete signs of imminent inflation emerge (e.g. wage growth >3.5% a few months in a row)
How much additional inflation above and beyond 2% is the US likely going to get over the next few years in scenario 2 compared with scenario 1? Do you really think that given the durably low inflation expectations, the absence of union power and the deflationary international low-growth environment inflation is suddenly going to jump to >5% in the US? How would the kind of massive sustained wage growth you need for that suddenly happen in an economy where the employers have for decades now gotten used to essentially never granting real wage increases?
On the other hand, what happens if you hike a few times and then you find that long-term rates are dropping? Suddenly you’ve inverted the yield curve. And then we’re all really, really screwed. The world economy is weak. If the US goes into a recession or even hits a serious growth snag, what will happen to China and Europe?
As regards the contribution of monetary policy in 2003 and 2004 to the real estate bubble – exactly by what mechanism would an interest rate higher by 100 bps or so have prevented or substantially ameliorated it?
The really crazy sh1t happened in 2005 and 2006, when interest rates where much higher, and all lending standards went out of the window.
Would the rapid increase in house prices – which had been going on unabated since 1996, regardless of changes in interest rate over that time period – have been arrested if the Fed had hiked just a little bit earlier? How?
Monetary policy was tighter in Europe and that didn’t stop the Spanish or the Irish.
The key “financial innovation” during the US bubble was that mortgages were designed which were incredibly expensive, while at the same time affordable to anyone…for a few years, until the teaser-rate period ended.
If lenders issue mortgage loans without regard to the debtor’s ability to pay interest or principal, and which instead rely on the sale of the house after a few years, what difference are 100 or 200 bps in the Fed fund rate going to make?
Personally, I think that the only way to abort the speculative fever of the real estate bubble through monetary policy would have been to cause a deep recession in 2003 or 2004. And even that might not have been enough – what if prices had resumed their climb afterwards?
Do you strangle the economy again?
Fighting real estate bubbles with monetary policy is like fighting lice by setting your hair on fire. It can work, but it is questionable whether if you get a better outcome than by doing nothing.
I don’t accept the responsibility of monetary policy in the 2008/2009 meltdown, because it would have been so very, very easy to avoid the damage through other means.
Prohibiting teaser rates and balloon mortgages and requiring a 20% downpayment (not financed with another loan) would have brought real estate price appreciation to an immediate halt.
Unfortunately, the policymakers at the time had forgotten that if you give the banks (and shadow-banks) too much rope, they WILL hang themselves.
@ James Kahn,
Forgive my snark, but there are some prominent economists out there other than Krugman that do not believe a quarter point rise in the interest rate is irrelevant and cannot be contractionary. Notably, Scott Sumner. Again like Advo mentioned, this could happen through the rate rise itself or for signals of future rate rises, but it is not an irrelevant move as you seem to suggest.
http://econlog.econlib.org/archives/2015/08/does_a_measly_1.html
Advo: “I don’t accept the responsibility of monetary policy in the 2008/2009 meltdown, because it would have been so very, very easy to avoid the damage through other means.”
I actually agree monetary policy wasn’t primarily responsible, but I do think the low rates in 2003-4 contributed, as financial institutions shifted toward riskier assets in a search for yield, which led to spreads getting compressed. And remember that the Fed Funds rate didn’t even hit 3 percent until mid-2005. But I agree that the regulatory side (both here and in Europe) played the more important role, though I would also add Congress’s coddling of Fannie and Freddie (who, contrary to popular opinion, were involved in subprime).
“an increase of 25 or 50 basis points will not cause a recession by itself – but it may if it causes the market to expect further tightening.
And hiking rates combats inflation by slowing down economic activity. I don’t think hiking rates by 25 or 50 basis points is going to have a large slowing effect (on its) own, unless it really shifts expectations. But then it won’t have a significant effect on inflation either, right? So why do it?”
The Fed is capable of communicating its expected path of rates, in fact that “forward guidance” has become part of its strategy. So they can accompany a 25 basis point increase by saying they are cautiously “normalizing” policy and will not hike rates aggressively unless inflation becomes more evident, or something along those lines.
The reason to do that now is because for whatever reason, the Fed is reluctant to raise rates rapidly even when it needs to, and inflation (perhaps as a consequence of that reluctance) seems to have a lot of momentum once it gets started. The point is just to shift a bit back toward “neutral” to avoid falling behind the curve as they have in the past. As I say, most recessions have come not from the first part of rate increases, but from continuing to increase rates to the point of inverting the yield curve.
On the 33-37 recovery: Remember ’37 was only 7-8 years after the onset in ’29, so roughly where we are now relative to 2007, and the growth in that period was tremendous. Industrial production did surpass the ’29 peak, after having fallen on the order of 50 percent, meaning that growth rates were double-digit. We’ve had nothing like that in this recovery. We’ve basically reverted to trend growth but on a lower level.
Daniel: Sure there are lots of economists that feel that way, but there are lots that do not, including some pretty heavy hitters like Bob Hall and Daron Acemoglu. My view is hardly an extreme outlier, even if it’s a minority. (Jeff Lacker on the FOMC also agrees.) I probably shouldn’t have singled out Krugman, as my point was more general about ‘appeal to authority.’ Scientific questions don’t get decided by majority vote.
I would simply submit that unless you predicted the recovery would be this tepid — despite the most expansionary monetary policy we’ve ever had, along with sizable fiscal stimlulus — you might want to think about why, and how we will assess this later if smoothing = pulling forward future growth as well. Sticking within the confines of traditional Keynesian analysis will likely only get you to “aha, your argument crumbles!”
Daniel – you might also want to respond to nivedita #19. And consider that policymakers do consider the wealth effect, I hope not too much.
1. “I actually agree monetary policy wasn’t primarily responsible, but I do think the low rates in 2003-4 contributed, as financial institutions shifted toward riskier assets in a search for yield, which led to spreads getting compressed. And remember that the Fed Funds rate didn’t even hit 3 percent until mid-2005.”
But investor demand for hideously bad mortgages didn’t abate in 2005 or 2006, despite the fact that the Fed progressively raised rates while lending standards went progressively down the toilet.
If investors were willing to buy the hideous vintage 2006 crap after Fed policy had normalized, why wouldn’t they have bought the much better 2004 vintage, even if treasury yields had been a percent or two higher?
I suppose this goes back to Greenspan’s “conundrum” and Chinese mercantilism depressing long-term interest rates. How much actual influence did US monetary policy actually have at that time, on the economy and the behavior of asset markets?
In any event, the high level of investor demand for garbage in 2006 suggests that a higher rate in 2004 wouldn’t have helped (much).
2. “Congress’s coddling of Fannie and Freddie (who, contrary to popular opinion, were involved in subprime).”
Yes they were, just not so much, and I don’t think they were relevant to the overall outcome.
I say that despite the fact that I started shorting Fannie and Freddie in 2003/2004 (which shows that being TOO smart is not beneficial). For purposes of drawing lessons for future policy, the important thing is that had the GSEs not been there, there would have been a lot more room for Countrywide and ist ilk, and I don’t think that would have made things any better.
The unfortunate thing about the GSEs is that the GOP has successfully used them as scapegoats, and conservatives have thus managed to avoid having to learn anything from the disaster, which virtually ensures another disaster in the future.
3. “On the 33-37 recovery: Remember ’37 was only 7-8 years after the onset in ’29, so roughly where we are now relative to 2007, and the growth in that period was tremendous. ”
It’s easy to have tremendous growth after the economy drops so far below potential. Despite the double digit growth, the US economy in 1937 was still far below trend. It might have made it back to trend in 1940, that means 11 years since the crisis began. That is a very long time, whichever way you look at it.
Today, we have the added problem of secular stagnation. Economic growth was weak in the 00s as well, considering that there was a massive real estate bubble which should have had the economy going red hot.
To me it seems as if the long-term natural interest rate has (for whatever reason) fallen considerably. This possibility should be kept very much in mind when thinking about what constitutes „neutral“ monetary policy.
4. You haven’t really said what kind of outcome you fear if interest rates aren’t hiked immediately. How much additional inflation do yo think that would bring?
@ Iceman,
It’s not hard to come up with an explaination. We are more interconnected with other economies than we were during the last big financial crisis (great depression) and the rest of the world is failing at a much higher rate, particularly Europe and the Euro. This exports our growth through weaker currencies? Make sense?
@Nobody.really:
“In short, I would expect risk-adjusted returns to fall. And fall and fall. ”
If risk-adjusted returns on business investments shift downward relatively suddenly (i.e. over the course of a decade or two), I would expect that fact alone to create substantial deflationary low-growth impulses because various actors would for a long time continue acting based on their assumption that the old paradigm still applies:
1. Monetary policymakers would think, for example, that very low interest rates are highly accommodating, when they’re really just barely so. They would probably cause two or three deflationary recessions before they realized that the paradigm had shifted.
2. Decision-makers in business would hold back on business investments because they would perceive the available returns as too low compared with historic standards. This would cause chronic underinvestment for a long time.
30 – it’s a fine hypothesis, but should hardly be the final word, yet. I’m not even sure Krugman would agree the world is more interconnected than ever before (e.g. Peddling Prosperity pp.258-9). It wasn’t too long ago the ‘traditional analysis’ also prescribed a simple trade-off between inflation and growth. Then when confronted with puzzlingly disappointing policy results, we gained important insights by incorporating ‘longer term’ factors like expectations.
31 – Your paradigm seems contrived to the point of obscuring its relevance – a surge in wealth materializes, presumably, as the result of highly rewarding investment opportunities, which we then presume are suddenly exhausted? In other words we become victims of our own success?
@Iceman:
“Your paradigm seems contrived to the point of obscuring its relevance – a surge in wealth materializes, presumably, as the result of highly rewarding investment opportunities, which we then presume are suddenly exhausted? In other words we become victims of our own success?”
Basically, yes.
I wouldn’t say “suddenly”, though – it’s gradual.
No, really we-re most definitely moreninterconnected than we were during the great depession. That’s not even uo for debate.
https://research.stlouisfed.org/fred2/graph/?g=2xdq
Daniel – sorry for delay, I was travelling. Thanks for the data, but since you’re comparing to the Great Depression we should shoot for a time series that goes back at least that far. Perhaps WWII depressed trade a bit?
I actually loved Krugman’s work on “national competitiveness” back in the day. This is from Peddling Prosperity: “the importance of international trade to today’s US economy is not unprecedented, or even unusual, by historical standards…19th century trade was accompanied by massive international capital movement, which were much larger relative to the size of the world economy than anything seen since World War I…[and] international migration that dwarfs anything recent”. And since I think your thesis would want to focus on “similar-similar” trade between developed nations e.g. US and Europe, in his Nobel speech he argues the world has been becoming more classical again: “the peak importance of increasing returns in industry location occurred circa 1930…from a peak in the interwar years, [regional manufacturing specialization] has declined dramatically”, and “for the last two decades, however, the trend has been…rapidly rising trade between advanced nations and much poorer, lower-wage economies”.
Advo: I mean I don’t find the thought experiment to be very reflective of reality, certainly not a theory. People always wonder where the next ‘new thing’ will come from. Sometimes success begets success, and demand is always infinite, including for things we haven’t even imagined yet.
@ James Kahn
https://www.stlouisfed.org/~/media/Files/PDFs/Great-Depression/the-great-depression-wheelock-overview.pdf
Essentially it is hard to compare this time to the great depression because there were very big positive monetary shocks that occurred during this time period that could have lead to a faster increase in investment, especially the introduction of the FDIC system. There is no comparable shock that is possible today. And isn’t it a bad example anyway. The pullback in stimulus in 1937 famously brought us back to recession. Also, you’re using a measure of industrial production (manufacturing, mining, and electric, and gas utilities) even though industrial production was a much larger part of the economy during this time period than it is now. If we look at other measures such as labor utilization we would not arrive at the same conclusion that you’re trying to present.
Iceman,
I highly doubt that as a percentage of the economy trade was as big a factor before and during the great depression as it is today, but if you have direct numerical evidence of this please present it. And no, we don’t need to focus on “similar-similar” trade. When the US dollar goes up relative to Europe, more people in the developed world want to buy Europe’s products than they do the US’s products, so you would want to look at the whole picture not just trade between the same countries of today and during the great depression. This is trade theory 101 and I thought generally accepted.
I thought you were suggesting specifically the US and Europe were more interconnected than ever and that feedback contributed to the overall sluggishness of the recovery for both. Relative currency movements would not seem to provide a general explanation for why both areas have done so poorly…or particularly why Europe has done worse.
@ Iceman,
The reasons Europe is doing poorly are obvious. The Euro mess is the chief and definite culprit which has nothing to do with the US and everything to do with non-central fiscal policy with a unified currency. As a result their currency has weakened relative to ours and so some of the growth that would have occured has not due to the fact that the rest of the world now finds European goods cheaper. Make sense?
Still seems like we’re focusing on 2nd-order effects. Your thesis as I understand it is that the reason the US recovery has been so disappointingly sluggish is because our fiscal policy was *more* effective than Europe’s, and that weakened our exports. Is the practical conclusion then that we should have done less?
What does seem clear is that our fiscal policy was less effective (in absolute terms) than hoped — certainly less than advertised by the proponents of the stimulus.
And our starting point here was focused on monetary policy (where the same lack of unity does not seem to exist w.r.t. the ECB), where the question was whether the tepid recovery (US +/or global) given unprecedented policy measures gives us any reason to reconsider certain premises – e.g. are there longer-term supply- / incentive- / expectations-related factors that warrant greater consideration – and for immediate purposes perhaps conclude that it’s in our interest to get off the zero bound sooner rather than later (may have been preferable to have already done so when the data / markets seemed to allow for a modest move). At this point asking whether less would have been more seems very much like a question worth taking seriously.
Iceman,
You’re spinning yourself in circles. I agree that we should rise off of the 0 bound if and when we can be satisfied that the economy will return to full employment on it’s own.
One, but not the only reason, this recession has been so long, even though monetary policy was moving in the correct direction and even though fiscal policy was moving in the right direction until 2011, is that Europe’s monetary and fiscal policy has been a complete disaster (not adjusting fast enough in the case of monetary and not moving in the right direction for fiscal policy). This depresses currency, this leads to higher global demand for their products and lower global demand for our products. Notice though that we have not done nearly as poorly as Europe but still less well than we could be doing if Europe’s policies had not been the disaster that they are. You want to look at fiscal and monetary policy as if it exists in a vacuum, where since we didn’t recover as fast as we first estimated we should assume it didn’t work. I want to take a more wholistic view that looks) at the effect thay other countries have on us in addition to our policy. How is this second order?)
You want to talk about long term effects? How about the decreased potential oitput due to long periods of unemployment for some people and the subsequent loss in human capital? You claim to care about the longterm while us keynesians and monetarists focus on the shortrun while completely ignoring the shortrun’s effect on the longrun.
@ Iceman,
My point is not to say that there weren’t other reasons our recovery was more slow, this was a housing financial crisis and therefore is naturally going to taje longer to resolve itself. The best comparison if we look onlynat the US is the great depression and James Kahn seemed to believe that we recovered faster until 1937 due to looking at industrial production. Why would we looknat this one instead of GNP or labor force utilization O have no clue which show us doing much worse during the great depression in 1937, idk, but even ifnwe assume pur recovery there was better than the great recession I was pointing to reasons that it might not have been like Europe’s complete failure. That’s what lead us down this rabbit hole.
I and other’s want to use the most direct comparison. How is the US performing in the same recession unde rsimilar circumstances compared to countries that have had different policy responses while James Kahn wants us to look only at past recessions for guidance eveb though the circumstances were nuch different in those periods. Obviously our way isn’t perfect but I’d argue it’s better than James Kahn’s comparison.
Thanks, sorry was travelling. Circularity was part of my point. I understand the offsetting (‘2nd order’) currency effect but feel there’s a potentially bigger story here. Trade seems still too small a % of US economy to be the driving factor. The qualms over Keynesian stimulus have always been over how the SR can impact the LR. Unfortunately Europe was farther down that curve to start with e.g. in terms of debt overhang which put them in a tough spot. I don’t believe the labor data detail has borne out the hysteresis notion too well thus far. The economy will always return to full employment eventually. But policymakers and wonks tend to be in the position of feeling someone must do something…illusion of control? Question — is it ever better to take more ST pain and ‘get it over with’ in order to more quickly get back to a more vigorous recovery?
@Iceman,
The problem is that shorterm pain sometimes turns in to long term pain because of the loss in human capital formation. What should Europe have done to allow a “quick” adjustment? Sometimes a sharply negative adjustment doesn’t precede a sharply positive adjustment if the government does nothing. It takes longer for prices to adjust downward in some cases, especially when employers are reluctant for whatever reason to cut wages of employed workers. Yes in the long run we will always get back to full employment, the point is it is preferable to get back to full employment more quickly since otherwise we lose that output, and our side believes that the government (through monetary and at the zero lower bound fiscal policy) can make that happen and your side doesn’t.
In other words, I believe you have presented a false ultimatum.
“Question — is it ever better to take more ST pain and ‘get it over with’ in order to more quickly get back to a more vigorous recovery?”
These are not the options I think we are presented with. I think it is more of a win-win or lose-lose situation. Is it better to get ourselves back to full-employment more quickly through government policies that promote full employment and thus have less short-term and less long-term pain or is it better to stagnate at below full employment thus hurting us both in the shorterm through directly lower output and in the long term through loss of human capital formation.
My “side” in this post is to point out that the current recovery has been disappointing relative to the amount of stimulus (as I think anyone would agree), in which case it seems fair and even incumbent to ask whether we might have done as well without as much of it – and also without the debt overhang on future growth. The debate probably does boil down to whether there are “natural restorative forces” whose signals we risk overriding with our policy responses. I think that’s worth doing a deeper dive on before we slough it off to secondary currency effects. Even Keynes said he reconsidered his views based on new ‘facts’.
If it represents a “side”, more generally I tend to view economics as the science of trade-offs: e.g., between growth and income dispersion (which is why many believe the focus should be on poverty not dispersion per se), or between ST smoothing and longer-term potential growth. Hysteresis is a theory which offers an elusive “best of both worlds” justification for activist policy (which policymakers may eagerly embrace), but this would seem in a way simply to presume what you want it to support – that policy action can *shorten* (not just attenuate) the cycle.