Continuing from where we left off in the earlier post, we reiterate that for stimulus seekers no stimulus is enough and no stimulus is too much.
I chanced upon this blog post (my misfortune) by ‘Free Exchange’ this morning. Apparently, this is in response to a response to his blog post. Without reading his original and the response by another, we can make sense (?!) of the issues by reading this one long post of his.
We shall state his assertions followed by our responses:
Assertion 1: It is fair to note that low interest rates, particularly low long-term interest rates, can encourage financial behaviour that might in some circumstances increase vulnerability to crisis. But long-term interest rates are determined by many different factors, including the outlook for real growth and inflation expectations.
Response 1:Excessively below normal long rates do not lead to real investment but to speculative investments. The U.S. economic expansion of 2002-08 saw the lowest annual growth in real non-residential investment in equipment and software and the lowest annual growth in employment despite record low short rates and lower-than-ought-to-be long rates. Japan is another prime example. It is the case because low rates alter expectations about future economic growth, for the worse.
Long rates may be explained by other factors but the principal factor is the short-term interest rate. Hence, if long rates did not rise much, despite strong US economic growth, it simply meant that the Fed could have done more with short rate hikes – both the pace and the quantum of rate rises between 2004 and 2006.
From William Buiter’s Maverecon blog post in 2008:
But the fact that on top of these very low risk-free long-term real rates, credit spreads became extraordinary low, had something to do with the liquidity glut created by the Fed, the Bank of Japan and, to a slightly lesser extent, the ECB. The Fed kept the Federal Funds rate target too low for too long after 2003. Because of the unique role played by the US dollar in the global financial system, the US dollar liquidity shower not only soaked the US economy, but also many others. First those who kept a formal or informal peg vis-a-vis the US dollar. Then those whose monetary authorities, without pursuing a dollar peg, kept a wary eye on the exchange rate with dollar, and ultimately most central banks in the globally integrated financial system. [Link]
Assertion 2: It is far from clear that Fed policy was driving indebtedness as Mr Klein alleges.
Response 2: It may not be clear only to ‘Free Exchange’. Fed policy – in actions and in speeches – dismissed bubbles and the lax regulatory response too part of the Fed policy framework. More honest introspection is needed on the part of the bubble-blowing Federal Reserve and its cheerleaders.
Assertion 3: Direct foreign-exchange market interventions* in the early 2000s would have been highly stimulative (though not popular in foreign capitals). They would also have leaned against capital inflows, and limited growth in America’s current-account deficit and in private indebtedness.
Response 3: Direct or not, the Federal Reserve policy of cutting rates to 1.0% and keeping it there was a foreign exchange market intervention of sorts. The purchasing power of the Euro in terms of the US dollar doubled from the year 2000 (October) to 2007. A gain of little over 10% per annum. The dollar weakened against most currencies in the world. It was a foreign exchange market intervention and it stimulated global bubbles as all countries raced to counteract currency strength or mute it with expansionary (or, reluctantly tight) monetary policies of their own.
Assertion 4: In 2003 the Fed was actively concerned about disinflation and the threat of deflation. Had it pursued a tighter policy path inflation would have moved even farther below trend. Now unless Japan is the financial stability ideal Mr Klein has in mind, one has to assume that he would support Fed action to actively combat deflation. But that would have meant moving interest rates down to 1% or below. It might also have meant use of unconventional policy; that was certainly something being discussed at the time.
Response 4: The Federal Reserve was wrong to have focused on disinflation. It relied on wrong data as it turned out. The following is an extract from Richard Fisher’s (Federal Reserve Bank of Dallas) speech in 2006:
A good central banker knows how costly imperfect data can be for the economy. This is especially true of inflation data. In late 2002 and early 2003, for example, core PCE measurements were indicating inflation rates that were crossing below the 1 percent “lower boundary.” At the time, the economy was expanding in fits and starts. Given the incidence of negative shocks during the prior two years, the Fed was worried about the economy’s ability to withstand another one. Determined to get growth going in this potentially deflationary environment, the FOMC adopted an easy policy and promised to keep rates low. A couple of years later, however, after the inflation numbers had undergone a few revisions, we learned that inflation had actually been a half point higher than first thought.
In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country. It is complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth. [Link]
One could also rather reasonably hypothesise that the Federal Reserve was focused on asset prices, either implicitly or explicitly. The extraordinary decline in the Federal Funds rate to 1.0% and the year-long tenure of the FF rate at that level was due to the anxiety on the part of the Greenspan-Bernanke duo to support asset prices. Willem Buiter could not have put it any better than he did here:
It seems pretty self-evident to me that the Fed under both Greenspan and Bernanke has responded more vigorously with rate cuts to sharp falls in stock prices than can be rationalised with the causal effects of stock prices on household spending and private investment or with the predictive content of unexpected changes in stock prices.
To me, the LTCM and January 2008 episodes suggest that the Fed has been co-opted by Wall Street – that the Fed has effectively internalised the objectives, concerns, world view and fears of the financial community. This socialisation into a partial and often highly distorted perception reality is unhealthy and dangerous.
It can be called cognitive state capture, because it is not achieved by special interests buying, blackmailing or bribing their way towards control of the legislature, the executive, the legislature or some important regulator, but through those in charge of the relevant state entity internalising, as if by osmosis, the objectives, interests and perception of reality of the vested interest. [Link]
Assertion 4: It’s worth pointing out that America did not avoid crises over those 70 years by consistently using monetary policy to lean against any unusual credit growth. In the six decades prior to the 2000s the use of tighter monetary policy to restrain credit growth would have prevented zero depressions while also reducing nominal output growth.
Response 4: Mr. ‘Free Exchange’ sets up too many strawmen and knocks them down. No one can remotely credit Federal Reserve monetary policy with seven decade prosperity. Even the Federal Reserve Chairmen would be a little more modest than that! In the 1930s, Roosevelt’s interventions restored growth. For nearly five decades after that, the US financial sector operated under tight restrictions. That is why they could not create too many bubbles. It is no credit to the Federal Reserve. Further, the extraordinary damage caused to Japan and Europe in World War II gave a free pass to US exports as the world capacity was being rebuilt. There was so much spare capacity worldwide that no overheating risk arose for nearly two decades until the US over-reached in Vietnam and began to feel competitive anxieties versus Japan and Germany. The Federal Reserve created a washout of the Seventies with its accommodative monetary policies. In the 1980s, the Federal Reserve briefly created a painful slowdown with sky-high real interest rates and that laid the foundation for the next two decades of bullish asset prices.
So, the only instance when the Federal Reserve ran a tight monetary policy, it paid rich dividends for the next two decades (roughly). Hence, facts speak otherwise than what Mr. ‘Free Exchange’ would like us to believe.
Assertion 5: There is a limit, in other words, to the horizon over which the Fed has permission to sacrifice short-run growth for longer-run growth.
Response No. 5: The converse is equally true. There is a limit, in other words, to the horizon over which the Fed has permission to prioritise short-run growth over long-run growth. Five years of zero per cent interest rate and four years of money printing are well above what most people would regard as a legitimate horizon for monetary policy to try and influence short-run cyclical output.
Assertion 6: economic history provides us with some very clear lessons on the nature of monetary policy under conditions like those at present. With both nominal interest rates and expected inflation uncomfortably close to zero, caution is a recipe for underemployment and stagnation at best.
Response 6: Economic history provides us with some very clear lessons too on the limitations of monetary policy under conditions like those at present. Accepting one’s limitation is the starting point of the road to redemption. It is also a less hubristic response. Between 2002 and 2007, America borrowed economic growth from the future with an extraordinary credit bubble. Financial globalisation and financialisation inflated that bubble. Without clearing away all the debris of the previously collapsed structure, one cannot rebuild a future edifice.
Assertion 7: Fed officials’ determination to prematurely back off accommodative policy has repeatedly threatened to tip the economy back into recession. That, in turn, has forced the Fed to roll out even more unconventional accommodation. The Fed’s balance sheet is probably much larger now than it would have been had the FOMC been much more aggressive in 2009-10. QE3 will almost certainly continue for longer than it would have had the pro-tapering bunch simply kept their mouths shut in early 2013.
Response 7: Let us be very clear because Mr. ‘Free Exchange’ is trying to be clever. Tapering is not prematurely backing off accommodative policies. When the Federal Reserve initiated QE3, it was four years after it initiated its unconventional monetary policy. It was meant to be an insurance against any meltdown in the Eurozone. Tapering is now a small withdrawal of that additional stimulus. The Federal Reserve will still be buying assets in the market. Nor would it shrink its balance-sheet under tapering. Nor would the Federal Reserve be raising interest rates. If anything, it has further pushed out the date for the commencement of normalisation of monetary policy, even without commencing tapering in September 2013. The Federal Reserve Bank of San Francisco has said, in a research note, that QE achieved very little in terms of economic gains. Monetary policy did not risk becoming prematurely tight with tapering. It was going to become a little less ridiculous. That has not happened.
The problem with the ‘you can never have enough policy stimulus’ camp is that it refuses to admit that it has been proven wrong and there are limits to how far one can defy normal and natural laws of economics. For them, Schumpter did not exist. They are trapped in their delusions and hubris as to how much their policy interventions can achieve, ignoring how much their policy interventions are distorting all the time. Indefensible.
For an antidote to reading ‘Free Exchange’, please catch up with Gilian Tett here and here.