The Fed’s Coming Indiscretion?

March 16, 2010

by Mario Rizzo  

There seems to be broad agreement among economists that the current recovery from the recession will be characterized by a slowly falling unemployment rate. This makes a good deal of sense since the problem that created the recession was a misdirection of resources into a number of sectors including housing construction and the financial industry.  

Reallocation of resources takes time. The government is not helping matters in trying to prevent adjustments by various (but not very successful) efforts to slow or reverse the rate of fall in housing prices. It is also difficult for market participants to determine the effect of possible new policies like Obamacare or any further jobs-stimulus legislation.  

The key uncertainty, however, is Fed policy. When will interest rates rise? When and how will the Fed pull back all of the new “liquidity” it created through quantitative easing – that is, buying securities other than Treasuries and paying for them with newly created money?  

Keynes argued for keeping interest rates permanently low and not for lowering and raising them as a counter-cyclical policy. One reason he argued for this constancy in policy is to eliminate the very uncertainty investors feel now.  

Of course this meant that if inflation threatened, Keynes would ideally use direct government control of investment to quell the pressures. I do not think this is a good idea because governments are bad at allocating capital resources (due to their ignorance of relevant economic facts and the pressures of political interests). 

Nevertheless, Keynes did understand the perils of policy-created uncertainty. Yet uncertainty from the point of view of economic decisionmakers is not the only issue. Another, closely related, matter is whether the Fed is likely to use its uncertainty-creating discretion well in restraining inflationary pressures as we exit the recession.  

A recent article in the Financial Times by Michael Bordo and John Landon Lane gives us a historical perspective, and the news is not reassuring: 

Our evidence suggests that if we follow the patterns of postwar business cycles, and if unemployment has peaked in the fourth quarter of 2009, we may see a tightening in the first quarter of 2010 but more likely in the second quarter. However, if unemployment falls slowly – and if the last two recessions are any guide – the Fed may delay longer. This raises concerns that prolonged maintenance of low rates will fuel future inflation. Indeed, the public’s rush into inflation-protected government bonds may be a harbinger of a future rise in inflation expectations.  

It is likely that unemployment will fall slowly. But, equally as important, whether or not unemployment will have peaked at any point will be fundamentally only an educated guess. 

The upshot is we are now experiencing policy-generated uncertainty – with more to come. This will in itself mean that unemployment is likely to be stubborn. And so, if the past is prologue, inflation is on its way.

12 Responses to “The Fed’s Coming Indiscretion?”

  1. Juan Carlos Says:

    why would you argue that: “…This makes a good deal of sense since the problem that created the recession was a misdirection of resources into a number of sectors including housing construction and the financial industry” when it is evident that job were lost (and are being lost) in all sectors of the economy???
    if too many resources were directed to housing and industry bu not to others, why are other sectors also shedding jobs??
    why did countries which did not have excessively large housing and financial sectors lose jobs??

  2. Lee Kelly Says:

    Juan Carlos,

    When the price of A falls, and producers of A receive less income, it is usually because buyers have started buying B instead, and producers of B receive more income. Total income/expenditure remains constant, and resources merely shift from producing A to producing B.

    However, what if the prices of A falls, producers of A receive less income, and buyers simply hold onto their money? In this case, the loss of income to producers of A is not offset by an rise in income to producers of B–there is fall in total income/expenditure. In both cases, buyers judge that too many resources are being expended on producing A, but while in the first case they know what they want instead, in the second case they don’t know.

    In the real world, away from simplications like this, an overexpansion in real estate effects other industries in all manner of unobservable ways. The larger the bubble and the bigger the bust, the more difficult it is to discen what industries derive what portion of their income, either directly or indirectly, from real estate. Suppose that construction workers tend to enjoy sports more than workers in other industries. Since construction workers are temporarily earning and spending more, television companies begin investing in shows to cater for that audience (responding to increased competition from advertisers). When the bubble bursts, and construction workers have less income, some proportion of sports shows may become unproftable. Thus, the enternainment industry is, to some extent, caught up in a bubble in the real estate industry. It takes little imagination to create other examples of how the allocation of resources, throughout the economy, may have been effected by the real estate bubble.

    Since the price distortion caused by a bubble can thread its corruption throughout the economy in unpredictable ways, a reduction of investment spending on A may not be offset by an increase on B. People perceive greater risk, resources are not reallocated, but rather neglected, and the effects of the bust are intensified beyond what is necessary to correct the original misallocation of resouces.

    Or, at least, that’s my story.

  3. Mario Rizzo Says:

    (1) Not every recession in all places has the same explanation. (2)There can be malinvestment in specific sectors which then via secondary processes (including fears of spreading demand declines) causes decreases in demand elsewhere.

  4. Juan Carlos Says:

    Lee Kelly: I have posed this question in one form or another in several blogs on several occations. I hace to say that yours is the most thoughtful and coherent response I have received. You managed to include the ‘direction of resources’ story in the framework of a monetary (as opposed to barter) economy.
    Thank you.

    Mario, let me see if I understand you correctly: would you say then that the fall in consumption and investment is a consequence rather than a cause of the crisis?

  5. Juan Carlos Says:

    *** That should be: “I have to say…”


  6. I also read the Bordo/Lane piece and was concerned with its conclusion. It is almost inevitable that the Fed will get behind the inflation curve.

    For the reasons Mario adduces, we will have weakness and slow growth in the near- to medium-term. Inflation later. (I predicted that scenario in a Dec. 2008 op ed in the NY Post.)

  7. Bill Stepp Says:

    Alan S. Blinder published an op-ed in last Friday’s Wall Street Journal, “Fed Vacancies and the Monetary Challenge.” The Fed’s job, he wrote, is to tighten “at just the right pace” by draining bank reserves and hiking interest rates. If it tightens too slowly, inflation might be in the cards. If it brakes too quickly, the economy might be back in a ditch.

    He wrote:
    “To say that the Fed’s navigators are in uncharted waters is a gross understatement. They don’t even know whether they are on land or at sea.”
    He went on to say that the Fed’s exit plans will have to be modified “many times and in many unpredictable ways as time goes by. Doing so adroitly will require both consummate technical skills and good seat-of-the-pants judgements.” But when Donald Kohn steps down, he continued, Chairman Bernanke will be the only board member who is a trained economist.
    He said that they need “three highly-skilled technocrats.” (You can’t make this stuff up.)
    I say: why not get three good Cuban or North Korean economic planners? I mean, don’t they have the requisite skills and the keen judgement required to determine what the target interest rate should be, and at what pace reserves should be removed from banks? The Fed is all about running a money monopoly and imposing monetary socialism, regulating banks and the payment and clearing system, so why not do so? Let’s get some real socialists in there, not these namby pamby fake pseudo-socialists.

    As Blinder concluded, “Well, a man can hope, can’t he?”

    Then let’s get on with the rapper Maynard K’s euthanasia of the rentier class, by abolishing interest.


  8. All too true, Bill Stepp.

  9. Pietro M. Says:

    Regarding Juan Carlos last comment, I must admit that the policy of paying interest on reserve is apparently contradictory with respect to all the rest of Fed’s policies.

    However, my tentative conclusion is that it has had no real effect on excess reserves, it didn’t cause its spike, it didn’t increased them, and it is unreasonable to assume that a 0.25% interest has a major impact, except if there is dearth of investment opportunities throughout the economy, which is of course dependent on some real process and not on Fed’s policies.

    1. They didn’t start paying reserves to calm down inflationary pressures: prices started to quench before October 2008. Apparently, interest on reserves didn’t affect the trend. There was a deep fall in October 2008, but was short lived.

    2. In December 2008 (after 2 months of existence) the interest on reserves fell to zero dot something. I would consider it inconsequential under all normal conditions, except when there are no risk-adjusted positive returns to be gained through the market, i.e., if the return on investments is zero throughout the economy, at least risk adjusted.

    3. Increasing the monetary base by monetizing toxic waste would have hampered the quality of the Fed’s balance sheet. However, what is not clear to me is how a 0.25% on reserves can have consequences.

    4. Excess reserves started to boom in August 2008, three months before interest payments on reserves. It didn’t grow after the start of interest payment, and it stabilized slighty afterwards. It has started to rise again after mid 2009.

    I see data compatible with the structural unsustainability (malinvestment) interpretation, but not with monetary contractionism by part of the Fed.

    Analysis based on FRED series: INTREQ1, EXCRESNS, CPIAUCSL.

  10. chidemkurdas Says:

    From Bill Stepp: “They need “three highly-skilled technocrats.”” Not only the Fed but many government agencies will need super-naturally skilled as well as altruistic officials if the various regulatory initiatives pass. Not just in the financial area. The health care bill presumes super-technocrats will rein in costs.


  11. Michael Kinsley muses about the coming inflation in the Atlantic (HT:David Boaz).

    http://www.theatlantic.com/magazine/archive/2010/03/my-inflation-nightmare/7995/


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