Although investors have been worried about the Fed’s exit strategy for some time, you wouldn’t see much evidence if you looked at the markets. While gold prices are an exception, the stock market appears to reflect optimism about recovery (although cynics would say it really is a function of liquidity, not fundamental views). Either premature tightening or a pickup in inflation would sully this pretty picture.
Thomas Hoenig voiced the concerns of the hawkish camp. The Fed’s traditional method for pegging interest rates is based on an approach called the Taylor rule, devised by economist John Taylor of Stamford. The Financial Times reports that Bernanke, in a speech defending the Fed’s policies, showed that using its own version of the Taylor rule as a guide, rates were too low in 2009.
The Wall Street Journal Economics Blog also describes some papers by Fed staff, one from the St. Louis Fed, the other from the Richmond Fed, both concerned about the possible resumption of inflation. But this strikes me as a peculiar focus, particularly in light of what just happened. Conventional wisdom is that monetary authorities have considerable latitude to resort to stimulative monetary policy as long as inflation remains tame. But we now have an environment, at least in the US, where labor has no bargaining power. Look at the last cycle, where the share of GDP going to corporate profits rose to record levels while worker wages were stagnant. And we had a period where interest rates were well below the level indicated by the Taylor rule for a protracted period. And what did we get? A big credit bubble.
Even though the Fed and other central banks recognize this danger intellectually, they have not internalized it. Indeed, many observers, including your humble blogger, believe that the “throw liquidity at the markets” program was to prop up asset prices (although the authorities rationalize that by telling themselves that they had reached irrationally depressed levels. Funny how they had no problems with irrationality when prices were frothy). So now that they are formally in the bubble reflating game, when can they tell that enough is enough? While they have some notion of what range of inflation is salutary, they have no such view re asset prices (and if they did, it might prove a tad inconvenient, since housing in some markets is still too high relative to rentals and income levels).
At least Hoenig gave a prominent role to the risks to stability:
“Experience both in the US and internationally tells us that maintaining large amounts of stimulus over an extended period risks creating conditions that lead to financial excess, economic volatility and even higher unemployment at some point in the future,” he said. Mr Hoenig rejected Mr Bernanke’s argument that the Fed decision to keep rates low after the dotcom crash did not contribute meaningfully to the housing and credit bubble. “Low interest rates contributed to excesses,” he said.
But Bernanke, in his eagerness not to repeat a Great Depression, is discounting the risk of another set of bubbles leading to an even bigger wipeout.
9 comments
Comments are closed.
Question: while loan rates are low, the spread between loan rates and the federal funds rate is very high. So does keeping the fed rate near zero really do much other than let the banks profit on the spread? Would raising the fed rate to say 1-2% increase loan rates by 1-2%, or would the change be less?
Just my opinion but raising the Fed rate like that would likely do in the carry trade in dollars and burst the current bubbles in stocks and commodities. As for the big spread in rates, I think this reflects the lack of lending and that banks will only lend if their returns are similar to what they can make off more speculative ventures which doesn’t happen much. The banks need these higher rates from speculations because they are insolvent and this is one of the ways they can recapitalize. At least until the next bubble goes splat.
“maintaining large amounts of stimulus over an extended period risks creating conditions that lead to financial excess”
I guess my question is what counts as “stimulus”. QE? Keynesian spending? I don’t see how reflating bubbles in the paper economy prevents deflation in the real economy. It may delay it but it won’t stop it.
I agree too that the central paradox of the last 30 years is that wage increases were seen as inherently inflationary and therefore to be curbed but steering this money to the wealthy and investors so they could create bubbles was never seen as a negative to be guarded against. The truth is that casino capitalism and the paper economy have been much more destructive to our country and its people than some garden variety wage inflation.
Hoenig makes most sense and does not seem to pander to anyone. In fact he might make a better choice as Fed Chief if US HAS THE LUCK TO DERAIL BERNANKE’S CONFIRMATION. That clown is the most stupid and stubborn fool on view right now!
“Look at the last cycle, where the share of GDP going to corporate profits rose to record levels while worker wages were stagnant. And we had a period where interest rates were well below the level indicated by the Taylor rule for a protracted period. And what did we get? A big credit bubble.”
That is TOP! With government running surplus, current account being negative, wages stagnant and GDP growing, private sector HAS TO BORROW. Otherwise national accounts do not work. Inflation, quantity of money, interest rates and so on is completely IRRELEVANT because consumer HAS TO BORROW
I think it was interesting that Ben used a derivation of the taylor rule to validate his policies only for John Taylor to turn round and say actually Ben you were wrong.
http://www.businessweek.com/news/2010-01-05/taylor-disputes-bernanke-on-bubble-says-low-rates-played-role.html
obviously, Mr. Bernanke wants to try something new –distinguish himself so to speak.
“cynics would say it really is a function of liquidity, not fundamental views”
I know you were being sly, but obviously I will replace “cynics” with “realists” in that sentence. Are sane, knowledgeable people really arguing that buyers could possibly be in the fundamentals camp at this point? After major, major downturns in the indices twice in the last decade, directly in response to rapid rises like we’re seeing now? The NASDAQ in particular is a momentum-chasing liquidity-fueled casino. There is almost no cash flow at all to these “investments,” just the possibility of selling to the greater fool.
The prices we’re seeing in liquid equities are totally out of line with the prices in illiquid debt securities and the stubbornness of banks to lend to real business (even on very low LTVs). This is a function of liquidity and ease of disposal being at a huge premium because the market does not expect this to last. All this does is set up the possibility (not the inevitability) of another steep downturn. Could be soon, could be a decade away, wish I knew.
Re: “economist John Taylor of Stamford”
It’s “Stanford.”