Once again we’re seeing a big divergence between what the markets expect the Fed to do and what the Fed expects the Fed to do.
Another one of the very interesting papers from the Jackson Hole Fed conference was by outgoing NBER President Martin Feldstein. After a very good description of how the subprime problems developed, Feldstein painted a frightening picture of what might come next:
The recently revised national income accounts show that personal saving fell sharply from 2.1 percent of disposable income in 2003 and 2004 to less than 0.5 percent in 2005 and 2006, a decline equal to about a $160 billion annual rate. I believe that a substantial part of that decline and the relative increase in consumer spending was due to the concurrent rise in [mortgage equity withdrawal] that resulted from low mortgage interest rates and increasing home prices….
If house prices now decline enough to establish the traditional price-rent relation– recall Shiller’s comment that a 50 percent decline in real house prices is “entirely possible”– there will be serious losses of household wealth and resulting declines in consumer spending. Since housing wealth is now about $21 trillion, even a 20 percent nominal decline would cut wealth by some $4 trillion and might cut consumer spending by $200 billion or about 1.5 percent of GDP. The multiplier consequences of this could easily push the economy into recession….
Feldstein argued that such concerns warranted a major reduction in the fed funds rate now, perhaps by as much as 100 basis points.
That would be a hard sell to some members of the Federal Reserve. A common estimate among macroeconomists is that consumers spend so as to keep total wealth intact. That would mean that in order to predict the effect on consumption spending, you would multiply the change in wealth by the real interest rate, which must be a smaller number than the 5% that Feldstein implicitly was assuming. Fed Governor Frederic Mishkin noted at the conference that the Fed’s basic model uses a spending factor of 3.75%. Moreover, Mishkin noted reasons that the marginal propensity to consume out of housing wealth could be even smaller, in part because your implicit personal cost of housing services goes up or down in step with whatever happens to the price of the home you’re living in.
It’s clear that Feldstein also failed to persuade Federal Reserve Bank of Philadelphia President Charles Plosser, who acknowledged in a speech given on Saturday that housing has exerted a drag on the economy, but doesn’t expect things to get much worse:
The ongoing correction in the housing sector has certainly contributed to slower economic growth during the past year. The persistent weakness in housing has also contributed to downward revisions in the outlook for the economy. Going forward, until housing demand picks up and some of the inventory of unsold homes is worked off, residential construction will continue to be a drag on economic growth. I expect this drag to diminish gradually but continue until sometime next year. I believe the most likely outcome is that economic growth will return toward trend later in 2008; however, there is considerable uncertainty surrounding my forecast.
Jim Cramer would also not be comforted by these words from Plosser:
the Fed does not seek to remove volatility from the financial markets or to determine the price of any particular asset; our goal is to help the financial markets function in an orderly manner. I agree with Chairman Bernanke that we should not seek to protect financial market participants, either individuals or firms, from the consequences of their financial choices.
Plosser in particular appeared to be unmoved by Friday’s employment report that worried most of the rest of us. Bloomberg reported:
Federal Reserve Bank of Philadelphia President Charles Plosser said that while the surprise loss of U.S. jobs in August was “not encouraging,” it doesn’t on its own justify lowering interest rates. “We want to be careful not to overweight one piece of information,” he said in an interview late yesterday after a speech in Waikoloa, Hawaii. “I’ve not made up my mind at all” on whether a rate cut is needed, he said.
It’s unclear whether yesterday’s report on Los Angeles home sales would help him make up his mind:
The expanding mortgage crisis and credit crunch slammed the Los Angeles housing market in August, with home sales plunging 50 percent from the same month last year and 25 percent from July.
At least the fed funds futures markets stood up and took notice of the employment report, with contracts on Friday predicting 4.94% for the month of September– that’s 6 basis points lower than on Thursday– and 4.58% for November– down 12 basis points in a single day, and suggesting a likely cut in the fed funds target of 75 basis points over the next two meetings. Apparently there were even rumors that the Fed would implement an intermeeting cut by 2:00 p.m. EDT last Friday.
Tim Duy thinks the Fed is boxed in by such market expectations, and is in despair:
Note also that gold broke out above $700, copper bounced today, oil is poised to make a run for $80, the Baltic Dry Index is off the charts, productivity growth is falling, and the Dollar is set to make another drop. Moreover, I suspect China will be revisiting their currency/foreign exchange reserve policies after the 2008 Olympics, adding to additional downward pressure on the Dollar.
In short, I think the Fed is rightfully cautious about the inflation outlook, but policymakers are likely to cut rates anyway. Historians should take note; I have a sick feeling that this is the moment the tide turned on the 25+ year battle against inflation.
Now, let’s be clear– a 25-basis-point cut at the September 18 meeting is a no-brainer. The effective fed funds rate ended up averaging 5.02% over the month of August, so declaring that the target is now 5.0% would be little more than ratifying the daily operating procedures that the Fed has been following since August 9. And, if you were persuaded that 5.25% was the right rate in July, I think you’d have to recognize 5.0% in August and September as an even more constrictive rate given the tightening of credit standards. For example, the London interbank dollar borrowing rate has been going up even as the effective fed funds rate has declined:
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Can the Fed begin as it must to cut the target rate and still avoid Tim’s slippery slope? I think so, and here’s how. They can clearly communicate they’re not panicked by the market or bullied by the politicians by waiting until the scheduled September 18 meeting before announcing a cut, and even then one or two members could cast a dissenting vote. Markets would see a 25-basis-point cut delivered in that manner as a splash of pretty cold water. If next month’s data show the same trends as last week (some comforting and some alarming numbers), the Fed could cut another 25 basis points at the end-of-October meeting, adding another dissenting vote. That would leave them free to move any way they want, up or down, in December.
If we get stronger confirmation that the August employment and LA home sales numbers are not an anomaly, the Fed should be prepared to make that a 50-basis-point cut for October.
All of this, of course, should also be accompanied by clear statements that we need some steps other than control of the short-term interest rate to deal with the problems that have developed. And some leadership from the Fed to get those steps implemented.
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Hummm …
Your thoughts on what should come (in Spetember) are my predictions on what will come (in September).
However, as a consequence of the equity market implosion which should follow the September meeting (as the “rush for exits” plays out) we will be treated to the customary “emergency telephone meeting” between regularly scheduled meetings followed by a panic rate reaction. Late September, perhaps early-mid October.
It looks like there is very little to stand in the way of a gold “moonshot.” Just what the central banks love to see. The ease of acquiring a position in that space (GLD and the like) will make this move very, very interesting.
I read a lot of commentary saying that if the Fed cuts only 0.25% at the next meeting the market is going to panic at this apparent under-reaction.
JDH wrote:
Once again we’re seeing a big divergence between what the markets expect the Fed to do and what the Fed expects the Fed to do.
…All of this, of course, should also be accompanied by clear statements that we need some steps other than control of the short-term interest rate to deal with the problems that have developed. And some leadership from the Fed to get those steps implemented.
Professor,
Love your opening and closing paragraphs. Your opening begs the question whose expectations are more important the market or the FED?
Your closing paragraph begs the question why has there been no leadership over the past 9 months?
I believe the answer to the first question is the market and so a 25 pt decrease in the FFR will not satisfy. We are in a serious situation and so a strong signal is required to demonstrate the FED is not wimpish when confronting economic problems. That would mean at least a 50 pt reduction in September. If that results in the desired effect then the FED can consider only a cut 25 pts in October. But because the entire country recognizes we have a problem demands action not a whimper.
Martin Feldstein wrote:
The recently revised national income accounts show that personal saving fell sharply from 2.1 percent of disposable income in 2003 and 2004 to less than 0.5 percent in 2005 and 2006, a decline equal to about a $160 billion annual rate. I believe that a substantial part of that decline and the relative increase in consumer spending was due to the concurrent rise in [mortgage equity withdrawal] that resulted from low mortgage interest rates and increasing home prices….
If saving is defined as disposable income less personal consumption expenditures the savings numbers quoted do not give an accurate picture. A very significant number of people who entered the real estate market were actually engaging in a method of savings.
The average man has been looking at systematic inflation since before 1971. That means that cash is not king. Anecdotally my daughter made this clear when she moved from the LA area in California to Las Vegas primarily because she wanted to “invest” in property by buying a home. To her buying a home was savings.
So I would venture to say that a reduction in savings is not because people were tapping the equity in their homes as much as it was people exercising a flight to hard assets in the face of increased inflation and rising home prices. Just as in the 1970s the average person was attempting to protect his assets against devaluation of the currency. (Part of this could also be an attempt to lower taxable income, mortgage deductions, to avoid the claws of the AMT tax predator.)
What about this comment from Richard Fisher of the Dallas Fed on Monday:
“I am guided first and foremost by a desire for my children to be proud of their dad; to be judged by them as well as by economic historians as having been wise rather than too smart by half, as having a steady hand rather than an itchy trigger finger.”
And this:
“Conducting monetary policy is not a popularity contest.”
Hi all,
I will add a comment in a bit.
Meanwhile, feel free to vote for the “FED forecast poll” on
http://thedailyeconomist.blogspot.com/
(my blog) there are also some opinions of mine about the FED policy.
Best
Bernardo
Seems like a big fuss over nothing. Here is an excerpt from John Hussman. The linked article has an interesting pair of graphs showing how fiscal policy correlates with inflation, but monetary policy not so much:
http://hussmanfunds.com/wmc/wmc070910.htm
“As it happens, the vast majority of the base money created by the Fed is drawn off as currency in circulation — very little is actually retained as bank reserves. Indeed, of the $15.9 billion in monetary base the Federal Reserve has created over the past year, all of it has been drawn off as currency, leaving bank reserves about $2 billion lower than last year. That’s not unusual. Total bank reserves have been gradually declining since the early 1990’s. Since then, in contrast to what I used to teach my undergraduates about ‘money multipliers’ and such, there no longer any link between the quantity of bank reserves and the volume of bank lending.
Moreover, it’s unclear exactly how changes in the Federal Funds rate presumably cause changes in market interest rates — statistically, market rates lead and Fed Funds typically follow. We can of course argue that, well, the markets are anticipating the Fed. But why do we really need so badly to believe that a government entity that influences an overnight interest rate on a $41 billion pool of money (this is the entire amount of U.S bank reserves) is actually in tight control of a $13.8 trillion economy?
Think about it. The full range of variation in the U.S. monetary base (including both bank reserves and currency in circulation) typically amounts to only about $50 billion annually. Over the past year, foreign holdings of U.S. government debt have increased by $300 billion — more than six times the fluctuation in the monetary base, and over a hundred times the amount by which U.S. bank reserves have changed.
It might seem that Fed must have an effect because periods of easing are typically followed by subsequent economic recovery, and periods of tightening are typically followed by economic softness, albeit with a long and variable lag.’ But that’s a lot like saying the sun comes up because the rooster crows. The Fed generally only raises the Fed Funds rate when the economy is near full capacity and continues until the economy softens. It lowers the Fed Funds rate when the economy is already weakening and continues until the economy recovers. The Fed is ‘effective’ as surely as economic softness follows strength and strength follows softness.
Even if a round of Fed easing will eventually be followed by economic strength, we should not prefer it. By that sort of logic, a major spike in unemployment would be a great thing, because as we know, such spikes are also typically followed by economic recoveries, though with a long and variable lag. ”
Can the Fed begin as it must to cut the target rate and still avoid Tim’s slippery slope? I think so, and here’s how. They can clearly communicate they’re not panicked by the market or bullied by the politicians by waiting until the scheduled September 18 meeting before announcing a cut, and even then one or two members could cast a dissenting vote. Markets would see a 25-basis-point cut delivered in that manner as a splash of pretty cold water. If next month’s data show the same trends as last week (some comforting and some alarming numbers), the Fed could cut another 25 basis points at the end-of-October meeting, adding another dissenting vote. That would leave them free to move any way they want, up or down, in December.
If we get stronger confirmation that the August employment and LA home sales numbers are not an anomaly, the Fed should be prepared to make that a 50-basis-point cut for October.
For a closed economy, this seems like a reasonable way to deal with the problems we face. But doesn’t the Fed have a bigger problem on its hands?
Long term interest rates are determined — at least in the current period — by the willingness of foreigners to hold American assets. If foreign investors see the US as committed to an asymmetric policy that ignores asset prices as they go up (and the financial shenanigans that they draw) and then supports them as they go down, will they start to look for less volatile and better managed markets?
The Fed has to be careful not to trigger the second stage of a perfect storm by setting off the unwinding of global imbalances just when that unwinding will do the most damage.
If the Fed wants to implement the monetary policy you recommend, it needs to simultaneously become a serious and convincing advocate of complete systemic regulatory reform — with details. In other words, I think your last paragraph is too weak.
If we want to maintain current levels of foreign investment, either the Fed needs to put into place less aggressive monetary policy than you recommend (signaling to investors that addressing the financial situation is as much a goal as addressing the real economy) or the Fed needs to convincingly lay the foundations of a financial New Deal.
JDH — do you think the FOMC adjusts the number of dissenting votes reported to the public?
Perhaps we’re lucky that while Plosser’s ” . . . not made up my mind at all” on whether a rate cut is needed, at least he doesn’t get an FOMC vote this year. He gets to attend and talk, but no vote.
On the great Libor/FF mystery, supposedly it’s because there’s a huge amount of CP maturing (as much as 70 billion pounds) in Europe between Sept 11-19th, with perhaps 23 billion pounds maturing on Sept 17th. Some are calling it “double rollover” week, and the banks have been hoarding cash in case the CP they’ve backstopped can’t be rolled and they have to provide liquidity to the conduit/SIV/SIV-lite.
The problem with the Fed playing it cool and only doing 25 bp on 9/18 is that if a bad-case scenario is playing out (as I think the most current data suggest), 25 bp in mid-September and another 25 bp in mid-October aren’t enough to forestall a recession which could take hold as early as November or December . . . . . . considering that Fed policy moves made today won’t gain traction in the real economy until sometime between December and March, if Feldstein is halfway correct the Fed is getting so far behind the curve that the ecoonomy may be into a death spiral before they can catch up.
JDH, your thoughts are very reasonable, and maybe the Fed will do something like the actions you describe. We should clearly recognize that this is in the realm of theater and image management. The Fed’s management of Fed Funds rates follows T bill rates up, and follows T bill rates back down. That’s what we’re seeing – again. The Fed is very useful as a lender of last resort to ensure liquid markets, and they can play a role in long term inflation management. But in the intermediate term, they do not manage rates or the economy. They follow the T bill rate. We can watch the T bill and get a 2 or 3 month head start (over Fed Funds rate changes) in understanding where the economy may be headed.
Seth, I have no inside information on how dissenting opinions within the FOMC get resolved. I can tell you on the basis of UCSD economics faculty meetings that the following is always a consideration on the part of a faculty member who disagrees with the majority– If I cast my officially recorded vote against the majority, what will the consequences of that official dissent be? Often as a result of such a calculation, a faculty member ends up voting with the majority even if he or she had serious doubts about the wisdom of the action. I’m observing that, in the present circumstances, a less-than-unanimous vote could actually be in the best interests of the Fed, which might embolden someone to “officially” dissent who otherwise might have cast their official vote with the Chair or the majority.
As for whether there may be “unofficial” dissent (by which I mean pre-meeting disagreements) within the FOMC at this point, I don’t think that is something anybody has to fabricate.
It seems every one is hoping for a rate cut to stave off a recession. Maybe a recession is need to reduce imbalances in the US. Perhaps we need a recession to build up savings and reduce the current account deficit. In the long term that is healthier. While people will lose jobs, US has a very high standard of living and the man in the street will cope and will still be better off than 80% of the world.
We all saw what happened with the loose monetary policy the last time.
In Asia we saw IMF advocating a draconian austerity measures during the crisis. That put the region in a recession but they recovered much healthier. While I do not advocate the same measures as the IMF, somewhere in between cutting and austerity measures will be best. So keeping interest rates as it is will probably be the balance.
Seeing the U$D Index sub-80, I’d think that the FedRes might even consider raising rates, at this juncture. Tim Duy’s points shouldn’t be lightly dismissed, Price Inflation/U$D (continued) devaluation is a serious risk. Any chance Bernanke has Volcker’s playbook?
Here’s the argument against a rate cut:
-Fed aversion to recession drives higher long term inflation.
-while cyclically inflation may decline, it will trough at higher levels than the last recession.
-the longer the process goes on, the higher real rates have to go to crush inflation expectations, and the deeper the eventual recession will have to be.
-we went through this in the ’70’s: the output gap was thought then, as now, to reduce the possibility of higher long-term inflation.
It would be interesting and educational, professor, if you could refute the above argument in one of your posts.
Richard Fisher said:
“Conducting monetary policy is not a popularity contest.”
Rex,
Fisher is wrong. monetary policy is almost all a popularity contest. If the popularity of the monetary authorities comes into question the value of the currency will tank. Markets act on expectations. If the FED demonstrates that they have a weak commitment to controlling the currency and that they appear confused, which seems to be the case right now, the entire economy will suffer.
This is one of the strongest reasons to take this massive power of monetary policy out of the hands of men and move it back in the impassionate standard of a commodity. Men are imperfect, they often evaluate good data properly, much less the flawed data the FED has to work with, and they are always subject to political pressure no matter how independent they think they are. The best case for a gold standard is being played out right now, as it has before, and as it will again as long as we try to live with a currency made of jello.
FWIW, here’s Greg Mankiw’s post regarding how to decentralize monetary policy:
http://gregmankiw.blogspot.com/2006/07/how-to-decentralize-monetary-policy.html
Re: “Fed Put”
Everyone talks about a “Fed put” and a moral hazard, and most know vaguely what it means. But does anyone ever clarify exactly what it means or how it works? When we talk about “moral hazards” does that mean Goldman Sachs is too highly leveraged relative to equity? Does it mean Joe Investor owns too many small cap or emerging market stocks which may get halved in market price during a panic, regardless of their fundamentals? Does it mean Fred Factory owner built too much capacity, not figuring on a credit market seizure?
Some bad bets work out well and some good ones go bad, but I’m just wondering what is the objective idea of too much risk taking or moral hazard, and whether it is supposed to differentiate between market risk vs. fundamental risk or poor business analysis vs. poor cyclical timing. The best examples of excessive risk takers, like Bob Citron and sub-prime borrowers, may not be performing the type of risk calculation that the notion of “Fed Put” would even influence – they just don’t understand what they are doing. In contrast, people who understood that tech stocks were in a bubble in 1999 had plenty of time to make and book huge speculative gains by the time the market started a downtrend – if they were sophisticated enough to think about a “Fed put” they were probably not holding tech stocks by the time of the first interest rate cut.
Josh, I believe that some may be referring to the “game of chicken” that I described here.
JDH, I liked and agreed with that essay the first time I read it, and feel the same way on a second reading. But I don’t see much evidence for the idea that this captures the main part of the Fed’s worry in the moral hazard dept. or the concerns of various folks urging them not to cut rates. Also, a lending entity that truly insolvent must be just at the brink of insolvency if a Fed cut of the magnitude being mooted would actually be sufficient to save them – in that case, maybe big losses is enough of a punishment.
September 10, 2007
The Economist points out that mark-to-market accounting (which is a hallmark of securitization) can be destabilizing; it can turn bankers from rather dry borrow-short-lend-long types into market speculators. I believe we are seeing this effect in the C…
Here’s the argument against a rate cut:
Well said. Isn’t it possible the Fed is going to let a US recession happen this time, for the long-term good of the global economy? (Talk about a thankless job)
For what TH? The long term good of the global economy?
I B go to hell.
JDH,
I was just wondering if there is such a thing as pre-emption of the recession by cutting on the Fed’s part.
If the market thinks that the Fed can always pre-empt the recession by cutting then it will behave as if there is a put. And then the Fed should not pre-empt the recession in order to restore the risk-reward process. So it should be late even if they know they should cut.
I think the core is that they should have targeted asset prices. Almost every central banker in Asia now targets asset prices because of the crisis. Singapore, China, India and Korea are all looking at asset bubbles under their
control- Property. They try to be early to defuse the situation. So central bankers should be early in tightening and then they can be early in cutting. Not in the current mess where you sat on your hands. When you cut early surely you are giving the wrong message.
Fred Miskin one of the Fed presidents advocates pre-emption in cutting. He also thinks we only know there is a bubble after the fact.
This is rubbish. If you can determine that fundamentals are going to deteriorate in the future and cut early surely you can determine that there is an asset bubble building and raise rates early.
This is going to be a game theory of sorts between the market participants and the fed. Both know that in the long run a cut is bad.
But viewing from each person’s perspective, a cut is good in the short run. Market gets to make money again and be bailed out. While the Fed is popular and will be called new maestro or something for saving the world. Both acting independently results in the long run bad outcome. How can we get the superior outcome? Independence of the central bank?
JDH, this game theory thought came to me in 5 mins while at work. Any known acacdemic papers
on this? Probably worth thinking through this more. Your thoughts please…
Plosser’s comments were astounding. JDH, I wonder if you have any thoughts how someone on the Fed can be that out of touch with the track record of the payrolls data. Decelerations of the kind seen in the last three months (NOT JUST ONE MONTH) are the kind that has always meant either a deep slowdown with Fed cuts or a recession. No exceptions.
Why is it that when the stock market goes down the fed needs to cut rates.It seem to me that we have to many cry babies in this world.Let the market run it’s own course,instead of manipulated it.