Will the Fed be Able to Respond to the Next Recession
On the blogosphere, there is an interesting debate about whether, when the next recession arrives, interests rates will be high enough that the normal approach of cutting the target federal funds rate will be sufficient.
In chronological order David Reifschneider, Jared Bernstein, Paul Krugman and Dean Baker contribute their thoughts (and in the case of Reifschneider extensive calculations and new research).
In an influential (pdf warning) paper , Reifschneider cautiously comes close to concluding that, given current Fed policy and in particular the 2% inflation target, the safe short term interest rate will probably rise enough before the next business cycle peak that cutting it will be enough.
Jared Bernstein thinks very highly of the paper, but is not convinced by the conclusion.
“I am not much comforted. There are a lot of “ifs” in Reifschneider’s story (all of which he is totally straight up about).”
if [skip] if [skip] if the QE and guidance have the positive growth and jobs impacts the model says they do; if people’s expectations are truly moved by the forward guidance, which implies future Fed officials will maintain the program. Then sure, sounds good.
Importantly, Bernstein is not convinced that Fed forward guidance actually guides expectations.
I think I will just quote (his explanation is better than my effort)
But I’m skeptical. The figure below, from Bloomberg News, shows a real problem for “if” No. 1. It draws a line through the “dot plots”: the Fed’s own predictions about where rates will go. The 3 percent at the end of the figure is the perch Reifschneider assumes they’ll get to before the next downturn.
The other lines at the bottom of the figure are the problem. They show market expectations of the funds rate and the fact that they’re so low creates a double problem for the Fed. First, if the markets are right, the limited firepower problem will be acute. Second, credibility. Remember, forward guidance works through market participants altering their expectations. At this point, the markets don’t believe the Fed’s projections.
It is very very clear that investors expectations about future Fed policy are not determined by FOMC forecasts of future Fed policy. At the moment, market participants expect a much lower Federal Funds Rate, but the point is that the listen, they hear, but they don’t necessarily believe. Regular readers know I totally agree and think this is a very important point. Also, I very much agree with “Re “if” No. 3, and again, Reifschneider is forthright on this point (I found his paper to be a model of clarity and caution), there are reasons to worry about whether monetary policy really has the growth and jobs punch the model says it does.” I have been worrying about overestimates of the effects of QE for 6 years now.
Paul Krugman agrees. As usual, he stresses asymmetric risks. He argues that “as Jared says, if the argument is wrong in any of several plausible ways — say, if the natural rate of interest is now much lower than it was in the past — this could be very wrong.”
Interestingly and unusually, Dean Baker disagrees with Krugman. Now I hate the fact that I almost never disagree with Krugman, so this raised my hopes.
Baker is brilliant as usual. He argues
… I can’t say I share their concern.
First, we have to remember that recessions aren’t something that just happens (like global warming :)). Recessions are caused by one of two things: either the Fed brings them on as a result of raising interest rates to combat inflation or a bubble bursts throwing the economy into a recession.
Taking these in turn, if the Fed were raising interest rates in response to actual inflation (and not the creative imagination of FOMC members) then we would presumably be looking at a higher interest rate structure throughout the economy. In that case, the Fed should then have more or less as much room to maneuver as it has in prior recessions.
The bubble story could be bad news, …
Baker then argues that it is possible to detect bubbles and prevent them from expanding to dangerous levels (sizes ? volumes ?) before they burst. This gives him another chance to remind readers of the many times he warned of the housing bubble before it burst, and of the fact that he warned that it would cause a severe recession when it burst.
I have some problems with this. First, I don’t think that even the very smart Dean Baker should be so confident.
Second it isn’t clear to me what should be done about a bubble which inflates without causing the economy to over heat. The housing bubble could have been restrained by high interest rates, but at the cost of high unemployment since it didn’t lead to extraordinarily low unemployment. And housing is the one sector which the Fed can most easily restrain. I’m not so sure that higher interest rates would have restrained dot com mania (fortunately the bursting of that bubble did little damage). I’d feel a whole lot better if I could think of a case in human history of a bubble which was restrained by the monetary authority (that is of a soft landing).
Third, and this is relatively important, it isn’t as if the USA has the exorbitant privilege of being the only economy which can initiate a world wide recession. There sure seems to be a huge construction bubble in China (a huge increase in leverage and also less concrete was poured in the USA in history than in the PRC in the last 3 hours or whatever). The USA doesn’t rely all the much on exports, but the correlation of GDP growth in different countries is much higher than that which can be explained through trade flows (writes Krugman who should know).
I am old enough to remember the Oil shocks. The recessions which followed the oil shocks look a bit like ordinary inflation fighting recessions, but, at the time, the unique features were very much stressed. I think it is in large part a coincidence that they followed periods of slack monetary policy, tight labor markets and accelerating inflation. I think such a shock hitting an economy with low inflation and anchored inflation expectations could cause a recession with low interest rates at the peak.
Finally what about total collapse of Europe ? It often seems possible over here.
“I have been worrying about overestimates of the effects of QE for 6 years now.” Me, too!
The MBS bubble was blown too big, I thought Greenspan was too facilitating in late 2002! So much that in2003 I considered buying a residence I felt it too inflated, and that was 30% below “peak”.
I hope Yellen does not go all Walter Mathau from Failsafe.
I have a problem with the thought that high interest rates would have stopped the housing bubble in addition to your noted effects on the rest of the economy.
The vast majority of the fraudulently created AAA buyers had absolutely no concern whatsoever for their adjusted interest rates down the road. They were either gong to sell and/or refi at another teaser rate.
Or so they thought.
Of course, many real people made the same mistakes as the investors who bought houses, but they were not the drivers of the bubble.
I’m with EMichael. The SF Bay Area had a sustained real estate boom starting in the 70s and extending through to the 90s even in the face of double digit mortgage rates. We sold a house in San Anselmo for I think $29,000 in 1971 that you couldn’t have touched for $700,000 in 1990 and truth be told not much different before or after the housing bubble 17 years later. For a middle income person it doesn’t take a whole lot of appreciation after tax advantages and the discount for rent to make home ownership in an otherwise desirable area outweigh straight out calculations of debt service.
Which was of course by total conscious policy design in the U.S. after WWII and was not in my recollection much effected by the stagflation of the 70s – those who could bought, those who couldn’t rented and movements of 25 or 50 basis points on 12 and 14% mortgages just didn’t have the drastic effects that current theory seems to think they should. Any cognizant even in the smallest way of SFR mortgage rates as they were from the 70s to the early 00’s should laugh at the idea that housing markets will crash if mortgage rates start nosing up above 4% or that individual decisions about buying owner occupied housing swing wildly around basis point changes. The question is “Can you swing the payment?” with perhaps “How are prices holding up?” and not about minutely examining the components of the mortgage payment. People just don’t operate with financial calculators in their heads.
Regarding housing bubbles, Dean has always pointed out that the Fed has other tools than interest rates to get specifically at the housing markets through various regulations, although those may only slow a bubble, and it is very hard to do so without it popping loudly. The Fed in particular has fewer tools to get at the stock market other specifically, leaving interest rates, which obviously threaten the whole economy.
SF is not a good indicator of anything. It and CA in general and also Mass. are notorious for way overblown land use restrictions that severely impact supply. Maybe it should not go all the way to Texan policies, which had not housing bubble at all in the noughts, but they could use some serious loosening. Housing prices have become ridiculous for little good reason other than puffing equity values for current homeowners. Gag.
There have been successful slowing of bubbles in history, although not very many. Robert, you of all people should know this. Go to Kindleberger’s Manias, Panics, and Crashes, Appendix B, which has gotten longer with more details in later editions. He (and successor) lay out detailed historiies of past bubbles, and one can distinguish those that a) crashed hard from the peak, b) declined gradually from the peak, and c) declined gradually for awhile in a period of distress and then crashes, these latter the vast majority, btw, although this is not widely known. We saw all three in this last round, oil the a case, housing the b case, and broader financial markets such as stocks, the c case. Obviously the housing bubble got way to extended, but it was higher interest rates that topped it off with its decline being gradual. The problem was that so much of the rest of the financial structure, especially in the shadow banking sector, was tied to it that we had this much broader set of crashes that took us into the recession.
And as a matter of fact, both Dean and Roubini jumped the gun on the recession forecast, which I noted at the time on Econospeak (and Dean agrees now I was right) because they said it would start end of 2006 due to falling construction from the decline in housing prices. Construction was declining, but the US economy kept growing for another year due to the low value of the dollar at the time, which kept exports growing.
Anyway, there have been some bubbles that declined gradually, most of those not leading to what happened in 2007-09.
RW asks,”Will the Fed be Able
to Respond to the Next Recession?”
Of course the Fed will be able to respond. As of today there are $11 TRILLION of government securities outstanding that have a negative yield. Europe and Japan have adopted negative short term rates.
The Fed could follow that and drop rates by a very important 2%. What would negative rates do in America?
IMHO it would flush out a lot of money that is now sitting idle and not invested in a productive way. It is money tied up in T bills and other short term securities. Banks are sitting on $2.2 trillion of excess reserves.
Today, the issue is not the cost of money, but the return on it.
Negative % rates would force money off the shelf. It would boost real estate and stocks. Those results would be a desired outcome of the Fed.
– Bank of Japan Gov. Haruhiko Kuroda said:
“Negative rates work and are nothing
extraordinary or immoral or absurd.”
And yet, if the money is not flowing though the hands of the masses in a way that allows them to have room on their credit reports, then what is messing with interest rates going to do?
At some point, the bubble is the false credit given to those who are well beyond the ability to pay it. We advertise cars as in a way that is selling a piece of it for a moment of use. Go and try to get the sales person to talk rate. They just want to talk payment. Why? Because they know that is what matter now. And, they payments have to keep getting smaller for the customer to be able to “afford” to buy.
The Fed’s can’t do squat is my opinion. Well, maybe the money from money people will be effect, but only for a moment.
The FED is not at this moment primarely afraid of causing recession by raising the funds rate(another 0,25%). The market knows this and understands why normalizing rates are essential. The FED worries more about the dollar-effect.