Tighten or Ease Rates?

From my perspective, deciding whether to tighten or ease is easy. It involves asking and answering a few questions:

Q: What is the current forecast for unemployment? A: It is that unemployment will stay around 10% for a year or more, and then slowly decline.

Q: Is that the path that we want unemployment to be on? A: No. We wish that unemployment would fall more rapidly.

Q: What should we do to make unemployment fall more rapidly? A: We should stimulate the economy through one of three tools--monetary expansion, support for the banking system, or larger short-term fiscal deficits--depending on which would work.

Q: Would monetary expansion work? A: Almost surely not. With short-term Treasury rates at zero, monetary expansion is all tapped out.

Q: Would further support for the banking system work? A: Quite possibly--but at the cause of greatly reinforcing incentives for moral hazard in the future, and voters appear really unhappy with the idea of giving Lloyd Blankfein more of the public's money to play with.

Q: Would larger fiscal deficits work? A: Almost surely yes.

Q: But wouldn't they greatly increase the national debt and exceed America's debt capacity? A: No. You know that the debt capacity of a country is about to be exceeded when the term structure of interest rates slopes upward very steeply--when interest rates on government debt are high and expected to keep rising. There is no sign of that right now.

But Greg Ip doesn't agree. He writes:

The American government reported on Thursday October 29th that gross domestic product rose at an annualised rate of 3.5% in the third quarter compared with the second. This was the first increase since the second quarter of 2008. It backs up other evidence that the recession ended in the third quarter or just before, though the official decision, by the National Bureau of Economic Research, a group of academic economists, is still some way off. Robert Gordon, a member of this group, is confident that the recession, which began in December 2007, ended in June. But at 18 months that would still make it the longest since 1933....A lot of third-quarter growth was the result of temporary government stimulus. Consumer spending grew by 3.4%, the best since early 2007, largely because people were buying new cars in July and August with federal “cash for clunkers”. Sales have since fallen back. Residential construction leapt by 23.4%, the first advance since the end of 2005, helped by an $8,000 tax credit for buyers of new homes. But new-home sales dipped by 3.6% in September, as the deadline to qualify for the credit passed....

Calls for a new round of stimulus look premature. Temporary effects aside, growth in the third quarter reflects the dynamics of a genuine recovery. Exports and equipment investment both rose. Companies ran down inventories at a slower pace, a contributor to growth that should continue for at least two more quarters. Construction is so low that, even with sales so depressed, the inventory of unsold new homes has hit a 27-year low. This suggests that construction should expand further. And Mr Gordon notes that employment is still falling because, following the pattern of recent recessions, firms have slashed costs deeply so that productivity has grown even as sales have fallen. Profits seem to have turned around already and Mr Gordon predicts employment will follow by the first quarter of 2010.

More stimulus now would add to an already dangerously high deficit. There may be greater need for it in a year’s time, when the inventory boost will be waning and this year’s $787 billion stimulus plan is about to expire. Even then, more stimulus should be considered only if a deficit-reduction plan is in place. In the meantime, monetary policy can assume the burden of safeguarding growth.

The markets expect the Federal Reserve to start raising interest rates by May, and there is speculation that at its policy meeting on November 3rd and 4th it will water down its current commitment to near-zero rates for “an extended period”. Given downward pressure on inflation, the Fed could instead stay on hold all next year, providing a safety cushion for the economy and taking some pressure off the battered federal budget.

Comments

[Faisal Humayun:]

Tightening or easing rates hardly helps...The central bank might lower rates but the private banks will tighten liquidity leading to relative illiquidity as it is happening now...

Even when Fed fund rates were 5.25% the credit growth was faster then it is not with Fed Fund rates at near zero level...

So in my opinion lower rates are just a tool for bankers to have easy access to money and go around speculating in the whole world...It does nothing good for the masses...

Nov 10 04:28 AM

[Dave Wrixon:]

The problem is that you are treating the Market as your Servant rather than your Master. When the Master finds out what is going on he is going to get really pissed.

The idea that you can use Employment as a target to manage the rest of the economy is nonsense. There are scores of failed Socialist experiments which show this to be a complete fallacy. Trust me I know, I have lived through the consequences of the failures of Old Labour's dreaming in the UK.

Nov 10 04:46 AM

[perceptions...:]

A. That depends on your goals!

Q. Why did Alan Greenspan leave rates so low, for so long after 9/11?

Nov 10 05:35 AM

[Michael Clark:]

To keep the debt bubble inflated. The Fed Chairman works for the banks not for the United States.


On Nov 10 05:35 AM perceptions_now wrote:

> A. That depends on your goals!
>
> Q. Why did Alan Greenspan leave rates so low, for so long after 9/11?

Nov 10 05:40 AM

[Michael Clark:]

Raise rates. This should have been done in 2001. Instead Greenie owered rates, sending the message that 'inflating' bubbles was his job.

Higher rates mean more savings and more savings mean less debt.

We have to wind down debt and contract the economy, get all the failing companies with unmanageable debt out of the system. Bankruptcy is a way of clearing the books, so we can start over.

Keeping rates low is just a way of putting banks first and trying to hide reality, with the hope that the crises in a storm that will magically blow over. There seems to be no understanding that INVOLVENCY IS THE STORM. The storm won't pass over by adding more debt (more insolvency) to the economy.

Is the government blind, scared or just owned by the banks? Probably all three.

Nov 10 05:44 AM

[Michael Clark:]

America should have had an upward bias in rates from 1965-1983. It did not. It tried to manage the Night-Cycle by flooding the system with cheap money then to, and we had recession and inflation at the same time, a horrible market...until Paul Volcker ratcheted up rates to choke inflation out of the system.

If we slowly lower interest rates during the expansion phases (1983-2001) and slowly raise rates during the contraction phases (2001 - 2019) then we won't have these wild swings between inflation and deflation. Of course, the banks want wild swings in inflation. That's how they get rich.

Nov 10 05:47 AM

[Kimball Corson:]

What should we do to make unemployment fall more rapidly, you ask.

My answer is attack it directly. Proceed with the derailed infastructure repair program and build a WPA around it that is broad enough to include local clean up, maintenace and repair and then reroute those receiving original or extended unemployment benefits into that program. If we had done that when infastrure program was proposed, we would be well underway now. The infastructure definitely needs the repair and the longer we wait, the more it will cost.

Too many government programs attempt ineffectively to attack problems with considerable indirection and obliqueness. An example here is the banks need to deleverage, so we drown them in liquidity, instead of running them thru FDIC or FDIC like proceedings to scrape their bad debt off. Another is, if we want lower mortgage rates, rather than pursue zero interest and QE policies targeted substantially on them, open a window and grant low interest rate mortgage loans.

We don't go straight enough to solutions for the problems we want to solve. We dance around them too ineffectively and throw money at them too obliquely.

As for the debt capacity of the country, I think it is more what the world and U.S. citizens decide and take it to be based in large part on the confidence they have in our government, and less on the slope of the yield curve of the term structure of interest rates on government debt per se. Causation runs from the former to the latter, I think.

Nov 10 08:06 PM

[peterfk:]

Q: But wouldn't they greatly increase the national debt and exceed America's debt capacity?
YES. The 2-10 spread is at record levels and the yield curve is very steep.

Nov 11 03:34 PM