Asking Too Much From the Fed

I remember a Federal Reserve economist once recounting a conversation with his young daughter, who asked him, "What do you do at work, Daddy?" He answered, "I help make important decisions." "What kind of decisions, Daddy?" "Oh, things like how much money the government needs to print."

That is an important decision - don't get me wrong. By creating too little money, a nation's central bank has the power to generate sustained deflation (a fall in the price level), such as the U.S. Federal Reserve did in 1931-33, greatly aggravating the Great Depression, or the Bank of Japan permitted in the late 1990s, undoubtedly prolonging the economic misery of that episode. These were outrageous policy errors, but ones that I am extremely confident that the well-trained fathers and mothers currently employed by the Federal Reserve System would never allow the United States to repeat.

The central bank also unquestionably has the power, by printing too much money, to create ferocious inflation-- just ask Gideon Gono, head of the central bank of Zimbabwe.

I happen to be among those macroeconomists who further believe that the Fed can do a great deal more than just cause too much deflation or inflation. The choice for the time path of money creation ultimately determines the time path of short-term nominal interest rates, and indeed the modern Federal Reserve quite appropriately conceives of its primary operating decision as basically choosing the current value for the overnight interbank interest rate, known as the fed funds rate. I would readily agree that careful exercise of this choice could help mitigate-- though in my opinion, not entirely eliminate-- the ups and downs of real economic activity associated with the business cycle.

I would also quickly point out that an injudicious choice for the short-term interest rate has the potential to exacerbate those ups and downs. Not just the potential, I dare say, but in practice has often been observed to exert exactly that effect. The cycle is an extremely familiar one. The Fed, frustrated by the low level of economic activity, tries to engender an artificial boom through lower interest rates, only to discover soon afterward that this has created more inflation than the public is willing to tolerate.

The Fed then has no option other than contract to try to bring inflation back down. But that contraction in turn may prove to be one factor contributing to the next downturn, to which the central bank wants to respond with yet another stimulus. In my opinion, this same pattern has been repeated many, many times in U.S. history, most recently with a Fed that was too expansionary in 2003-2004, which caused the Fed to have to contract in 2006, and that policy-induced boom-bust cycle is part-- though in my opinion, only part-- of the cause of the problem we find ourselves in today.

So, I am certainly a believer in the potential real effects, sometimes for good, sometimes for ill, of monetary policy. But I just as certainly do not believe, nor should any reasonable person believe, that no matter what the economic problem might be, you can always solve it just by printing more money.

What's an example of a problem you can't solve with monetary policy? Suppose you were convinced that house prices in the United States were at the moment substantially higher than they should be relative to the price of other goods and services. How could that have happened, an economist would want to ask, and let's suppose that the answer is that a credit market profoundly distorted by moral hazard problems loaned vast sums to households that could not reasonably be expected to be repaid if real estate prices stopped rising. The purchase of the properties financed by those loans drove up the price of housing relative to what it would have been (and should have been) with a correctly functioning credit market, so now the relative price of housing must fall.

And why doesn't the price fall instantly to the appropriate equilibrium value now that these problems are fully revealed, an economist would then reasonably inquire? To which the answer might be, home sellers reduce prices only gradually in a down market, as a consequence of which further price declines are presently quite predictable, as are the additional new defaults that would result from those price declines, as are the consequences of those yet-to-be foreclosed homes coming back for resale onto the market.

The problem then is many hundreds of billions of dollars in loans that are not going to be repaid, the prospect of whose default could completely freeze the market for credit.

That, it seems to me, is a problem you can't solve by lowering the fed funds rate. Even if the nominal yield on T-bills were driven all the way to zero, the same is never going to happen to the risky long-term housing loans we're discussing, nor to the rates charged for loans to the financial institutions exposed to the underlying default risk. And even if you could successfully engineer a further reduction in the nominal interest rate charged to home buyers, if the expected real estate price depreciation is large, that would dwarf the effect of the nominal interest rate itself in terms of the attractiveness to a buyer contemplating purchasing a home at today's prices.

You could in principle solve the problem of overvalued house prices by printing so much money that you bring the price of everything else up to that of housing, generating the necessary adjustment in the relative price of housing without going through the painful cycle of bankruptcies and foreclosures. Whether that is an action you'd want to contemplate might depend on the magnitude of the price adjustment you think is necessary. If we are talking about just 1 or 2% more inflation, I personally would regard the inflation as worth it. But if house prices are today overvalued by 10-30%, for which our proposed remedy is to bring about a corresponding increase in the price of everything else of that magnitude, we would surely want to bear in mind the recent caution from Federal Reserve Governor Frederic Mishkin:

Empirical evidence has starkly demonstrated the adverse effects of high inflation.

Now, reasonable people can and do differ on how likely it is that further Fed rate cuts would help mitigate the current problems. You might reasonably argue that even if the chance of success is small, the cost of letting the economy slip into the cascading defaults that a further 20% decline in real estate prices would precipitate is so large that it's worth trying anything.

And perhaps it is. But I would nevertheless caution that we need to be open to the possibility that no matter how low the Fed brings its target rate, it may not arrest the unfolding financial disaster. Unless the intention is to go all the way with enough inflation to avert the defaults, that means we need an exit strategy-- some point at which we all admit that further monetary stimulus is doing nothing more than generating inflation, and at which point we acknowledge that the goal for monetary policy is no longer the heroic objective of making bad loans become good, but instead the more modest but also more attainable objective of making sure that fluctuations in the purchasing power of a dollar are not themselves a separate destabilizing influence.

I am worried that everyone now seems to be looking to the Federal Reserve for a solution, and the Fed seems to be signaling that it is going to provide one.

Comments

[roger maxims]

Wake up and smell the roses James.

The Fed knows how much chips it has - not only $700bn reserves, but oil price, gold price and the price of every single commodity you have never heard of. All denominated in greenback.

Nobody in the world, perhaps Soros excluded, would ever allow high levels of inflation or even hyperinflation to happen in the US. It is a political and economic minefield.

Until and unless ECB, BOE, BOJ, PBOC and friends sit together behind closed doors and plot against the Fed it is a stalemate and status quo remains.

But then again that's what happened to Japan in 1989, of course. In the meantime, get out of that ivory tower will you? The trade's been banned since time immemorial.

[User 163007]

Obviously it has happened here before. The double digit interest rates of the Volker era spring immediately to mind. Since the US doesn't control the price of basic inputs like oil, or the inflationary knock on effects from China, and appears to be taking the MBS and ABS onto its own balance sheet I think the case for increasing inflation and continued dollar devaluation is quite good in the absence of rate hikes.

[roger maxims]

Perhaps you can understand this by an example:

1. US inflation for this year is 10%. Oil is US$ denominated.

2. Oil price rises 10% as a result.

3. Euro rises 10% but Yen rises only 8%. You cannot have identical appreciation rates across the board because of interest rate differentials.

4. Europe has lower inflation but less competitive exports; Japan has higher inflation but more competitive exports.

5. Both lose out.

[flow5]

You ignore the actual flow of funds:

From a systems viewpoint, commercial banks (money creating depository institutions) as contrasted to financial intermediaries (non-banks) prior to the DIDMCA; (S&Ls, MSBs, CUs), never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing Transaction deposits, or time deposits or the owner’s equity or any liability item.

When CBs grant loans to or purchase securities from the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) and every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money-transaction deposits.

What should be done? The commercial banks should get out of the savings business (REG Q in reverse). What would this do? The commercial banks would be more profitable - if that is desirable. Why? Because the source of all time deposits within the commercial banking system, is demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts. Money flowing "to" the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know.

The growth of the intermediaries/non-ban... cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.

In other words, competition among commercial banks for TDs (removal of interest rate ceilings) has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the "thrifts" (non-banks) with devastating effects on housing and other areas of the economy; 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds; 4) shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment.

Take some accounting.

[iThinkBig]

So nicely articulated flow5

[roger maxims]

Sorry I ain't no banker nor accountant to start with. So all of that analysis went into left ear and exited right ear.

Instead, I have my popcorn ready to watch "America - the land of the rising sons of George Bush Sr."

As of today, Ken Watanabe ("Last Samurai") has agreed to help Spielberg make this 4-hour film focusing on a stagant, decaying big apple for 10 years.