Monetary Policy overshooting a Recession?
Tim Duy wrote a post yesterday called, Heading into Jackson Hole. He gives a broad perspective of the economy relevant to monetary policy, which of course will be the major topic of discussion in Jackson Hole.
He recognizes that wages need to rise even though firms complain of not being able to fill job openings.
“Anecdotally, firms are squealing that they can’t find qualified workers. Empirically, though, they aren’t willing to raise wages.”
Then he talks about the Fed wanting to fight inflation instead of an economic downturn. In other words, the Fed would rather keep monetary policy loose to support economic growth and risk inflation, instead of tightening too early and creating an economic downturn.
He cites an article from Reuters, Yellen resolved to avoid raising rates too soon, fearing downturn, by Howard Schneider and Jonathan Spicer.
“…The nightmare scenario she wants to avoid is hiking rates only to see financial markets and the economy take such a hit that she has to backtrack. Until the Fed has gotten rates up from the current level near zero to more normal levels, it would have little room to respond if the economy threatened to head into another recession.”
His view is that the Fed should overshoot inflation to the 2.25% – 2.5% range. But my view is that the economy will not be able to make it back up to 2.5% inflation before the next recession due to the following reasons…
- As the Fed continues to project lower nominal rates in order to overshoot the inflation target, inflation will stay muted due to the Fisher Effect. (I have written about this before.)
- The effective demand limit is biting in Europe and will soon bite in the US. The economy will peak out in spite of the Fed keeping nominal rates low. Therefore the Fed will most likely be caught with an effective zero-lower-bound rate going into the next recession.
- Inflation will be subdued as consumption will under-perform because capital income is dropping its consumption as asset prices stall.
- China will want offload its massive production at lower prices. We see investment and lending highly reduced recently there. (link) China is up against its own effective demand limit. It will try to suck what it can from the US market at competitive prices.
- Wage growth will stay mild in the US, even as hiring increases. Unemployment is still relatively high. Price hedging is muted, which will mute wage offers. Mr. Duy recognizes the price trap upon wage growth.
“Margins serve as a line of defense against inflation. In fact, I would imagine that Yellen’s ideal world is one in which margins are compressing because stable inflation expectations prevent firms from raising prices while tight labor markets force wage growth higher.”
Tim Duy has hope for the direction the Fed is heading with monetary policy.
“Yellen seems content to normalize slowly until she sees the white in the eyes of inflation.”
Mr. Duy is content with that too. … but… time is up. The effective demand limit is already hitting in Europe, China and coming to the US in spite of accommodative monetary policy all around. There is not sufficient time to anywhere near normalize policy.
We can also look at an article from CNBC, Could weaker oil be signalling Doom for Stocks?. I agree with the view that lower oil prices is signalling a demand problem globally.
“…current global growth forecasts may be too optimistic and depressed demand in Europe and China, along with the anticipated normalization of interest rates in the U.S. and the U.K., could be about to bring investors back down to earth.” – Michael Hewson
I wrote a few times directly to Tim Duy over a year ago about the effective demand limit. He sees the economy being able to return to the previous full-employment. Keynes said there was an effective demand limit that could keep the economy short of full-employment. You would think the signs of that would be immensely obvious now, even if you didn’t have a model of effective demand… oh well.
I’d have to agree with Duy. Governments can return to full employment if they want to.
I don’t understand the mechanism by which the effective demand limit causes recession. It sounds like what they say about stagflation in the 1970s, but the economic context is much different now.
As I understand it, recessions were caused by the Fed raising rates. And then there are balance sheet recessions, but even in 2007 you had the Fed raising rates for it was overly concerned about inflation not moderating.
Tim Duy also referred to that belief that recessions were caused by the Fed raising rates.
So then we are left with the conclusion that recession are caused by the Fed. Maybe the most that we can say is that recessions are triggered by the Fed raising rates, while the economy is teetering on the effective demand limit.
I want you to look carefully at the following graph…
You see the Fed funds rate plotted against the UT index which shows the effective demand limit. The effective demand limit that hits the end of a business cycle is where the UT index goes to zero.
Now, notice that when the Fed rate maxes out, most of the time the UT index hits its low. But also realize that the Fed rate starts rising almost every time before the UT index hits its low. The Fed sees the economy heating up with signs of output hitting its natural limit.
So UT index falls toward the end of a business cycle… The Fed reacts to control the economy from by-passing the natural limit.
Now the Fed rate hits its max in May 1989. Then dropped. But the recession didn’t officially occur until September 1990. The Fed rate was falling and stalled just before the recession. On the other hand, the UT index was rising showing a contraction of the economy. Did the Fed cause that recession in 1989? or were they trying to react to things already in motion?
Now look at 1995… The Fed raised rates as the UT index went to zero, but there was no recession. The economy stayed on the effective demand limit for 2 to 3 years with the Fed rate elevated. Then the UT index started to rise with increased labor share and lower capacity utilization. The Fed tried to balance the bubble effects, but eventually the bubble ran its course and the economy contracted.
Then go to 2005, the Fed started to raise the Fed rate during 2004. The UT index was falling fast toward the natural limit of the economy. When the UT index hit zero, the Fed rate maxed. But that was still toward the end of 2006, a year before the recession. The Fed rate and the UT index stayed at the natural level for a year before the recession started to take hold.
One thing is certain… recessions cannot be avoided. They are a natural part of the business cycle. The UT index shows the business cycle. The Fed rate is trying to respond near the natural level of output.
The question in your mind now is… Can a recession be avoided if the Fed rate stays low? The answer is no… A business cycle has to fulfill itself. A recession will occur even if the Fed keeps rates at the ZLB as long as it can. Once the economy hits the effective demand limit, there is no where for it to go. Utilization of labor and capital are capped. Profits cannot increase with more utilization of labor and capital. Eventually marginal firms are weeded out at the end of the business cycle, easy monetary policy might keep them alive for a bit longer, but their days are numbered.
I will end by saying that the economy can go into a recession in spite of the Fed keeping policy as loose as they can.
But how could Greenspan have a hand in recession even if he did raise the rates? 9/1/2000 it peaked and then a race to the bottom at 1.73% in 2002.
The economy was doing well at 4-5% Fed Rate. It was only when Fed Rates maxed out at 6.5% in 2000, the economy started to slide. Did Greenspan bring on a recession as I pointed out an others disagree on or did he not? One says oil prices brought on he recession:
<iI will end by saying that the economy can go into a recession in spite of the Fed keeping policy as loose as they can.
Am I correct in concluding hat this is the exact antithesis of the Market Monetarist view point?
When companies can go shopping for middle management to control materials upwards of $100 million annually and demand 10 years of experience, a Bachelors degree at minimum, and a desired Masters degree besides NAPM certification; we have move to the incredulous when the wages offered are $80 to $90,000. Eventually reality sinks in to offerings when people go elsewhere.
“One thing is certain… recessions cannot be avoided. ”
Based on the politics behind policy making, or based on a mechanism that requires cycles?
Could we not have avoided the last recession if our ability to understand that housing was a problem? There was not one in the 90s because we got a shock (dot-com mania) that changed our growth pattern. Can we not just stay at what some people think is substandard growth without actually sliding into recession?
“I will end by saying that the economy can go into a recession in spite of the Fed keeping policy as loose as they can.”
To put it another way, eventually there comes a time when consumers and/or businesses can’t or won’t borrow more money. And if their spending slows enough then there will be a recession.
See D.2 Borrowing by Sector. Total non-federal borrowing in billions.
Quarter Total nonfederal borrowing Difference from 2000 Q2
2000 Q2 1376.2
2000 Q3 1027.6 -348.6
2000 Q4 1089.4 -286.8
2001 Q1 1005.4 -370.8
2001 Q2 1251.0 -125.2
Consumer borrowing did not fall as much as the other nonfederal borrowers especially businesses. And the recession started in March 2001.
So I agree with you that this was a case where the FED really did cause a recession. Why did they raise the Fed rate in 2000?
Here is an article from 2000 that gives a reason for the raise in the Fed rate.
“In 2000, Greenspan raised interest rates several times; these actions were believed by many to have caused the bursting of the dot-com bubble. However, according to Nobel laureate Paul Krugman “he didn’t raise interest rates to curb the market’s enthusiasm; he didn’t even seek to impose margin requirements on stock market investors. Instead, he waited until the bubble burst, as it did in 2000, then tried to clean up the mess afterward.”
The same as ignoring irrational exuberance, what was demonstrated was not having a clear handle on what he was doing in the increase to 6.5% Fed Rates. Why else would you raise Fed Rates if not to slow the economy down? When was the last time we have seen the Fed raise margin requirements on banks and investors? Maybe 2000? There were other tools at his disposal too such as reserve requirements for banks. Going from 5% to 6.5% in a year certainly helped the market along in crashing. The last time Fed Rates exceed 6.5% was 1990.
Seriously, did he wake up one morning and say; “hey, I am gonna increase Fed Rates for the heck of it?” Certainly there was a motivation for this. What is all this rewriting of history for a man who had the biggest impact on the economy since The Depression and the Seventies?
Thanks for this link from March 2000: http://money.cnn.com/2000/03/21/economy/fomc/
With this quote: “But a growing contingent on Wall Street is beginning to publicly question why the Fed is not acting more aggressively — particularly with the economy expanding at a near 7-percent pace, with wage pressures beginning to build, with oil prices near all-time highs, with prices for some goods and services beginning to rise and with the country’s trade deficit at a record.”
Which gave me this link from January 2000: http://money.cnn.com/2000/01/28/economy/economy/
With this quote: “The economy’s rate of expansion during the past three years has rung in faster than what Fed officials have said can be sustained without a renewed inflation threat. Fed officials have stated at different intervals that a “comfortable” rate of growth is typically around 3 percent.”
Three years earlier would have been January 1997 which was about the time that home equity withdrawals began to increase at a faster rate.
See page 16 Table 2 line 1 “Free cash resulting from equity extraction [(2)+(3)+(4)]”:
So consumers were spending more than they were earning and the economy was expanding at a near 7% rate.
Yes, let’s raise interest rates so that the financial institutions get a bigger cut of this monstrosity. That was the effect anyway.
Keynes said this…
“Now, we have been accustomed in explaining the “crisis” to lay stress on the rising tendency of the rate of interest under the influence of the increased demand for money both for trade and speculative purposes. At times this factor may certainly play an aggravating and, occasionally perhaps, an initiating part. But I suggest that a more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital.”
Chapter 22… There is more in that chapter.
He says what I have been saying. The cause of recessions is not primarily a raise in the interest rates, but rather a profit maximization point that leads to a decay through marginal firms.
Can anyone imagine a world where the Fed funds rate never rises just to avoid a recession?
The key to the discussion we are having here about recessions and higher interest rates is found in chapter 22 of Keynes…
‘Moreover, even if over-investment in this sense was a normal characteristic of the boom, the remedy would not lie in clapping on a high rate of interest which would probably deter some useful investments and might further diminish the propensity to consume, but in taking drastic steps, by redistributing incomes or otherwise, to stimulate the propensity to consume.”
Basically raise labor share. This happened in the late 90’s and Bernanke made a speech saying that we had conquered recessions. But raising labor share has its limits.
Just a quick comment and then I have to run.
The Great Depression and the Great Recession are a different breed than an ordinary recession as experienced after WWII.
They were both brought on by excessive debt which makes the Fed Funds rate more important.
The QUARTERLY REPORT ON HOUSEHOLD DEBT AND CREDIT for the second quarter of 2014 has just been released.
The Total household debt for Q1 was $11.65Trillion and for Q2 it was $11.62Trillion. So consumers are not raising their debt levels.
Nothing here to contradict your expectations about a recession.
Ed, As others here know, I am not an economist (just a scientist). But many things at AB remind me of process control where processes are kept in bound before they run amok. (Coberly’s SS comments often fit this model.)
Why is it that, instead of keeping the economy humming at a healthy pace, economists seem to be comfortable with taking thing to almost the explosive limit and then watching as the process gets dramatically adjusted to the point of almost a shutdown?
How do your models conform to reasonable bounds on economic activity (healthy, in other words). Can you see an end to the current hot to cold cycling. Is attempting to influence harmful run-away processes dangerous?, socialism?, a violation of free markets?, or what? Can the Fed do a better job by modifying or changing their paradigm? If not the Fed, who?
You bring up the most important concept… Sustainable.
Can the natural level of output be sustainable? In other words, can we maintain full-employment in a sustainable way?
Others will say that tightening monetary policy will collapse full employment. I think that full employment is more stable and sustainable than it used to be due to better real time monitoring of costs and profit rates. Thanks to computer technology. Firms are less likely to overshoot profitability and then less likely to snap back into a contraction.
My guess is that economists can not do much better because:
1. The collected economic data is insufficient.
2. Economics is in its infancy. Similar to weather forecasting in the 1950s before widespread use of computers. The economy is so difficult to document that they resort to simplistic models. (How many assumptions are required per simplistic model?)
3. Economists take simplistic positions. Full blown panics or depressions are not like the much more common recessions. The primary underlying problem in Japan is not the same as in the US or Europe. Their world is idyllic, it is as though ALL automobiles must have exactly the same steering and braking characteristics, their SUV’s roll over at exactly the same rate as their Corvettes.
4. Do economists understand feedback loops or that the Fed has become part of one? Or that feedback loops have a limited effective range and can induce behavior that is difficult to understand. There was no recession in 1937, it was just a continuation of the Great Depression after some of the government spending was reduced. But that does not seem to be understood.
5. How much of current economic gospel exists because of a political need. Say’s law was reduced to ‘supply creates its own demand’ in the 1930s and Jack Kemp argued supply-side virtues in the 1980s. Reduce taxes and investment would improve the economy, demand was just assumed. He had a lot of influence during President Reagan’s administration. We all know how that has turned out over the last 30 years.
They did not predict the Great Recession and they are still arguing over the cause, six years later. Alan Greenspan discovered ‘flaws’ in his thinking about regulation of the financial institutions but only after the fact.They worry incessantly about moral hazard when considering raining money onto the population, but had no serious concerns when they rained money onto the financial institutions. They can not consistently and accurately predict what the economy will do next year but they make 10 year projections. They can bring an argument to a dead stop with “Correlation is not causation”, no counter argument is necessary.
In other words, they are doing just about as good as they can. If they were honest, they would admit that it is like herding cats. LOL