Willem Buiter is no armchair Fed-sniper:
“Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.”
He has penned a terrific column which should be mandatory reading for anybody who wants to understand the duties of the Federal Reserve, how dismally the Fed has failed those duties, and why the USD has become a global laughingstock.
Should the Fed raise interest rates?
The US economy grew at an unsustainable 4.9 percent rate in the third quarter of 2007, which includes almost two months since the ‘official’ start of the financial crisis on August 9. Admittedly almost a full percentage worth of this growth was inventory accumulation. If his was unplanned, it may predict future planned inventory decumulation. Even 3.9 percent GDP growth, though, is still well above the Fed’s estimate of the growth rate of US potential output (recently revised down to 2.5 percent per annum) and even above the slightly more optimistic estimate of potential output growth of around 3.0 percent per annum of the Bush administration and many private forecasters. So the recent evolution of the output gap makes for higher inflationary pressures.
I don’t buy the 3.9% growth rate, because I think it significantly understates inflation. Not that that’s a surprise to anybody.
… There are indeed many pointers to a slowdown of domestic demand growth. Although there should be no significant negative wealth effect on US consumption from the decline in US house prices (what the average American consumer loses as a homeowner (s)he gains as a consumer of housing services), the decline in housing wealth will impact consumption negatively through the ‘housing wealth as collateral for consumption loans’ channel. The financial turmoil has raised the cost and reduced the availability of external funds to the household sector. Three-month Libor has recently stood more than 60bps above the official policy rate rate, and the spread of three-month Libor over such measures of the market’s expectation of the official policy rate over a three month horizon as the overnight indexed swap rate (OIS), is close to 100bps. Because many loans to households and non-financial corporates are priced off three-month Libor, there has been a significant degree of effective interest rate tightening, countering the relaxation of monetary conditions associated with the weakening of the US dollar.
As the Fed tries to fix the price of debt, the debt market over which the Fed has no control is sprinting in the opposite direction. This is why I have harped so tediously on the “Ted spread,” the spread of Treasury rates over eurodollar contracts (which are priced by Libor, the private inter-bank offer rate).
This layering or pyramiding of financial institutions and the explosion of new financial instruments created by them was to a significant degree driven by the twin motives of regulatory avoidance and tax avoidance. Part of it reflected genuine institutional and technical innovation not driven by regulatory and tax efficiency. This may well have contributed to more efficient risk trading during normal times and under orderly market conditions. These developments also make abnormal times and disorderly market conditions more likely and the associated financial crises deeper. The failure of regulators to keep up with the proliferation of instruments and institutions, the lack of transparency of many of the new instruments and institutions (negligible reporting obligations, mysterious governance practices) has reinforced the periodic eruptions of euphoria and hubris that are inherent in financial capitalism.
As the banks and their financial media toadies howl for every conceivable manner of bailout, it’s important to realize that “securitization,” that tediously overused word, was initially efficient because it was such a total end-run around toxic tax and regulatory mechanisms. These mechanisms spawned huge chains of derivative trades designed to offshore virtually all exchanges of risk. It eliminated 99.9% of the tax and regulatory liabilities, but it also massively increased long-run counterparty risk. Now all that counterparty risk has spawned a Category 5 hurricane of risk– completely contrary to the mission of taxes and regulations which fund the national institutions which would allegedly control these same animal spirits.
There can be no doubt that private consumption expenditure (about 70% of US GDP and also by far the most stable component of GDP) is going to weaken significantly. And so it should. The long-overdue and necessary increase in the US private saving rate is a necessary domestic counterpart to the long-overdue and necessary reduction in the US external trade deficit, which is the contribution of the US (necessary and long overdue) to global rebalancing. Consumption growth will have to fall significantly and may well have to become negative for a year or two.
Heresy in US policy circles. Common sense in the real world.
However, as soon as there is any sign of weakness in consumer demand, both Feldstein (who mooted a 100bps Fed rate cut at the August 2007 Jackson Hole conference) and Summers (who wants the Fed to cut aggressively to forestall a recession brought about by weaker construction activity and consumer demand) run to the nearest exit from the home of intertemporal sustainability screaming for a Fed bail out. Summers in particular appears to be willing to make any opportunistic sacrifice of economic good practice in order to minimise the risk of a short-term slowdown. He has proposed, for instance, that the two GSEs (government sponsored enterprises) Fannie May and Freddie Mac be allowed to weaken their balance sheets further to make off-budget (from the point of view of the government) quasi-fiscal transfers to financially challenged home owners unable to service their mortgages. He has also argued in the FT’s Economists’ Forum of 25 November 2007, that “…fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens.”
Where is the logic in calling for a higher saving rate when whenever a higher saving rate threatens to materialise, policies and gimmicks are invoked to lower the saving rate again? Summers’ recommendations for avoiding a downturn are an example of the kind of weak-kneed opportunistic approach to demand management policy in the US that has reinforced what appears to be structurally low private saving propensities in the US these past 40 years or so. There are serious consequences, both internal and global/external of this opportunistic myopia. Domestically, private and public provision for old age and retirement is becoming progressively more inadequate. Externally, the US has moved inexorably from being the world’s largest external net creditor to being the world largest external net debtor. This has weakened and will continue to weaken the global power and influence of the US and its government. It is difficult to go against the wishes and interests of those who own a growing chunk of you.
So I’m not the only person who went ballistic over Summers’ insane, neo-paleo-Keynesian policy prescriptions. That’s a good sign.
The concept of intertemporal sustainability, which I have remarked upon before, is crucial to this discussion.
The Fed has accumulated a certain amount of credibility over the past century. It can choose to depreciate its credibility rapidly at a massive discount by debasing the dollar according to the decibel level of self-serving squeals emanating from Wall Street, or it can think for itself, restore a modicum of functionality to monetary policy, and restore its inflation-fighting credibility.
It’s pathetically hilarious that even the TIPs market, which understates inflation expectations by a vast and uncertain extent, has recorded soaring inflation expectations. To insist that “inflation remains contained” is readily falsifiable propaganda.
Throughout the crisis, the Fed’s communication policy with the markets has been atrocious. My fear is that this communication policy mess reflects a deeper confusion/disagreement in the Fed about how to respond to the crisis, and about both the ultimate and the proximate objectives of monetary policy.
The speeches by Vice Chairman Donald L. Kohn on November 28 and by Chairman Ben S. Bernanke on November 29 had as their sole purpose to clean up the mess left by careless speeches earlier in November by assorted FOMC members who had left the impression that it would take a miracle (or a disaster) for the Fed to cut rates at the December 11 meeting. The self-evident superiority of a strategy where FOMC members say nothing in public that in any way anticipates future Fed rate decisions has obviously not occurred to anyone. [ha ha!-ed] The Fed’s monetary policy actions (decisions on the Federal Funds target rate) and its liquidity policy actions (decisions on the discount rate, on eligible discount window collateral policy, on eligible discount window counterparties and on its open market operations, both through repos and through outright purchases) speak louder than any words. The written statements released following FOMC meetings and other policy actions fill the rest of the information gap. Anything else is, at best, cheap talk. At worst, it confuses the markets and puts the Fed in the awkward position it has found itself in so many times recently. Too often, ambiguous signals extracted from unnecessary speeches by FOMC members force the Fed to choose between appearing to be a captive of the markets (by validating the markets’ expectations – which tend to be very close to the markets’ wishes – regardless of whether these expectations make any sense) or appearing to be desperate to re-establish its operational independence and room for manoevre by deliberately surprising the markets – ‘teaching them a lesson’.
… What is equally striking … is the fear of the financial markets among key Board members, regardless of their view on the Fed’s mandate. They fear a large fall in the stock market; they fear financial market turmoil; and they can be moved to cut rates if there is a sufficient crescendo of anguished voices from the financial markets and money centre banks. We all know that the Great Depression of the 1930s started with a stock market collapse and was aggravated by bank runs and a misguided monetary policy. The collapse of the multilateral trading system was the final nail in the coffin. Perhaps our central bankers have studied the 1930s too much.
Music to my ears.
Financial markets and private financial institutions deserve the attention of the policy makers. They are an important part of the transmission mechanism of monetary policy and an important source of shocks that could have implications for systemic stability; the information conveyed by asset prices and other market indicators must be monitored carefully and interpreted thoughtfully. But they only matter to the extent that they impact on the real economy. Today’s overgrown, bloated and highly vocal financial markets and institutions are getting more attention than they deserve.
The Fed and other US policy makers appear to be constitutionally incapable of taking the long view. Instead they are flailing about in a desperate attempt to minimize any short-run economic pain. By doing this, they also prevent necessary and unavoidable medium-term and long-term adjustment. This institutionalisation of myopia and resistance to change may well be an accurate expression of the unwillingness and inability of the US polity and public to take the long view in virtually any area that matters, be it monetary policy, fiscal policy, infrastructure investment, energy pricing and security or global warming. It is probably the clearest evidence that we can expect an accelerated decline in the global role of the US.
To answer the question in the title of this blog: probably not yet. But I would not cut the Federal Funds target rate either.
While I am not a fan of injecting extraneous heuristics into an argument, i.e. global warming (which I think is one of the most bloated, most heavily tithing and most apocalyptic religions on the market today), I am in total agreement on Buiter’s perception of the utter myopia in American institutions.
I also disagree with the assertion that the Fed is “constitutionally incapable of taking the long view.” Bill Martin was ok. Volcker was excellent. Greenspan, at least in his first couple of terms, was ok. The academics Burns and Bernanke, however, have been terrible.
What Buiter is referring to by that quote is, presumably, the Fed “mandate” of full employment, as specified by the 1978 Humphrey-Hawkins Act. As I have previously noted, that mandate is extremely subjective. For example, 1% higher employment today in exchange for 10% lower employment tomorrow, as a result of capital depreciation from a weak dollar, is obviously a much bigger long-run violation of the Fed mandate than it is a fulfillment of the short-run mandate, and as such would be a blatant violation of an intertemporal reading of Humphrey-Hawkins.
If I can figure this out, so can Bernanke. Unfortunately, Apache Ben’s apologists have sometimes hidden behind a myopically literalistic interpretation of the law as a justification for their own weakness.
I have always thought that American universities are about as myopic as you can get for an institution. Universities are great for innovating in technical fields beyond the ken of 99% of the population, in which the total supply of minds which can cope with the subject matter is simply very limited: e.g., molecular biophysics, nanoengineering, and astrophysics. The university system is a very effective market maker for the tiny populations of “traders” in those esoteric fields of knowledge.
But in areas like politics, economics, and such, the university system is just a myopic competitor to highly liquid external market-based analysis. University-originated policy prescriptions inevitably tend towards ratifying pre-existing biases and wallowing in risk aversion, as Summers has so shamelessly done. Academic policy recommendations tend to shun real solutions, which often require bloody frontal assaults on vested special interests in society. Academic malpractice of the Summers variety gives a green light to American political institutions to impose a “bipartisan, blue-ribbon consensus” bailout of the financial industry at the expense of American society.
It’s too bad that Larry Summers and similar academic priests are accorded so much respect. In my bombastic opinion, there are profound misallocations of respect and credibility within American society, in the direction of extremely risk-averse institutions in finance, government and academe. Why is the myopia of American financial policymaking so much more obvious for people whose professional reputations and futures are not hostage to American institutions, than it is for American observers and commentators?
The total lack of rebuttals and refutations of Buiter-esque arguments from American sources is also alarming. Usually, when a respected free-marketeer from outside the country levels such a devastating indictment of an American political institution, well-meaning Americans will snipe back, often with some decent points, and some kind of thoughtful, enriching debate will ensue. In the case of the Federal Reserve’s consistent failure, there has been no such riposte from American sources.
The silence is very curious.
(h/t to Yves Smith for the original pointer.)