Watching the Fed

We monetary economist types are all rooting for Ben Bernanke and company, as they try to figure out what interest rate level is consistent with maximum purchasing power, employment, and growth and also with price stability. And so we are all giving him and his committee advice: contradictory advice:

Marty Feldstein says that uncertainty is enormous, and the task of attaining a "soft landing" very difficult, but that on balance his judgment is that the Federal Reserve should keep raising interest rates:

WSJ.com - The Fed's Difficult Task: [T]he interest rate hikes of the past two years could soon cause a significant and sustained economic slowdown, bringing down future inflation without the need for further rate hikes. Although it is too soon to tell, some FOMC members may oppose a rise in the interest rate at tomorrow's meeting because of this possibility, and because of their fear that another rate increase could lead to an unnecessarily deep economic decline. The published forecasts of the FOMC members do not capture the full range of each individual's views. While stating that the most likely growth is 2.5%, an FOMC member may also believe that there is a risk that the growth and employment picture could be substantially worse.... As Alan Greenspan emphasized, monetary policy is a balancing of risks and cannot be made on the basis of the most likely projections alone.

The consequences of the past interest rate hikes are difficult to predict. The fall in the real level of house prices has caused residential construction to plummet, with housing starts off 14% from 12 months ago. The combination of lower housing wealth and a sharp fall in mortgage refinancing may cause the household saving rate to return to a positive level, bringing down consumer spending. Business expenditures on equipment and software slowed sharply in the most recent quarter. So a much sharper slowdown than the central tendency forecasts is certainly possible.

While this risk provides a rationale for a pause at tomorrow's meeting, it would be wrong to focus just on this downside risk. The probability that inflation will rise above the FOMC forecast is at least as great. The unemployment rate of 4.8% still represents a tight labor market. Waiting for more data before deciding to raise rates is not costless. If the Fed does not act and core inflation continues to rise, expected inflation may rise further. Higher expected inflation would cause faster increases in wages and prices. If the core PCE inflation rate rises above 3% in 2007, it would take a very substantial slowdown and a large loss of GDP and employment to bring it back under 2%.

In assessing the current interest rate decision, the FOMC members should recall that during the Volcker and Greenspan years the Fed pushed the fed funds rate to 8% above the concurrent rate of CPI inflation in the early 1980s, to 4% in 1989 and to almost 3% in 2000. That measure of the real fed funds rate is now less than 1%.

The Federal Reserve has a difficult task ahead. It is understandable that it would like to achieve the soft landing of low inflation with continued solid growth. But that may not be possible. And if the Fed wants to convince the markets that inflation will be contained in the future, it must show that it is willing to take the risk of tightening too much.

And John Berry writes for Bloomberg that last Friday's slightly depressing labor market report should have tipped the scales in the Federal Reserve's mind in favor of a pause--of not raising interest rates this week:

Aug. 7 (Bloomberg) -- The July labor market report tipped the scale in favor of a pause in the Federal Reserve's drive to raise interest rates to keep inflation under control. After 17 consecutive increases in the target for the overnight lending rate to 5.25 percent, officials should take a pass at tomorrow's Federal Open Market Committee meeting.

With the number of payroll jobs up only 113,000 and the unemployment rate rising to 4.8 percent from June's 4.6 percent, the Aug. 4 report provided further confirmation -- if any was really needed -- that U.S. economic growth has slowed significantly and may continue to do so.

Certainly the door is open for the FOMC to leave rates unchanged tomorrow. After digesting details of the labor report, investors put the probability of another rate increase at only 17 percent, down from 41 percent the day before, according to federal funds futures contracts on the Chicago Board of Trade.

That suggests there wouldn't be much of a backlash from analysts wringing their hands about Fed Chairman Ben S. Bernanke being ``soft on inflation'' or about the loss of Fed credibility as an inflation fighter. After all, a pause would be just that....

The issue, of course, is whether the 425 basis-point increase in the target since June 2004 will be enough to cap the recent acceleration in core inflation, which is now higher than the officials would like it to be. At least a few FOMC participants would prefer to see another quarter-point increase tomorrow, partly because they remain concerned there is so much liquidity available that monetary policy isn't biting.... [O]thers would prefer a pause, particularly given the lags with which changes in real interest rates affect the economy. A substantial portion of impact from those 425 basis points has yet to be felt, in their view.

In a speech on July 31, Janet L. Yellen, president of the San Francisco Fed, acknowledged those lags, which in both 1995 and 2000 caused the Fed to continue tightening too long....

Business investment in structures, equipment and software -- which many economists, including those at the Fed have been counting on to take up the slack as consumer outlays weakened -- increased at only a 2.7 percent rate in the quarter. All of the growth was in investment in structures while businesses trimmed equipment and software spending. Moreover, revisions to GDP for 2003, 2004 and 2005 showed that business investment was not as strong as earlier estimates indicated....

[E]ven with core inflation higher than Fed officials wish, a pause tomorrow in raising the overnight lending rate again makes sense. Overshooting didn't make sense at the end of the Fed's last two tightening cycles, and the FOMC ought to pause before doing it again.

And, of course, there is Brad DeLong in Salon http://www.salon.com/opinion/feature/2006/08/03/recession/:

"The Odds of Economic Meltdown: With interest rates and oil prices rising and consumers spending beyond their means, we may be headed for recession -- and worse," Salon (August 3, 2006)

Brad DeLong

http://www.salon.com/opinion/feature/2006/08/03/recession/

Aug. 3, 2006 | Forecasting recessions is a fool's game. If there is enough solid economic information to make it appear highly likely that a recession is coming -- that production, unemployment and consumer demand will actually fall -- then it is highly likely that there already is a recession. Businesses are not stupid, and they don't have to wait for economists to tell them what they already know. By the time a gloomy forecast has been issued they've probably already noticed a drop in consumer demand and responded by firing workers and reducing production.

So: Never say that a recession is coming. Say only that a recession is here, or that there might be a recession on the way. Which, in fact, is what I'm saying today. As of the beginning of August 2006, a recession is not here, and I'm not going to violate my own rule by saying one is coming. But there is a good chance -- for the first time since 2003 -- that there might be a recession in progress six months from now. Why? Three factors: 1) A Federal Reserve that finds itself with less inflation-fighting credibility than it thought it had; 2) upward pressure on inflation from rising energy and, perhaps, import prices; and 3) millions of middle-class homeowners who for too long have treated their houses as gigantic ATMs, using home equity loans and refinancing to generate extra spending money.

First, the Federal Reserve, now chaired by Bush appointee Ben Bernanke. The Federal Reserve sets interest rates, and when it does it tries to hit the economy's sweet spot: that point that produces maximum employment, purchasing power and growth without generating enough upward pressure on prices to produce expectations of inflation. The Federal Reserve does this by pushing interest rates up and down. Push interest rates up and businesses find it more expensive to expand capacity and production, causing them to cut back on investment spending. Push interest rates up and households' balance sheets deteriorate, causing them to cut back on consumption spending. Push interest rates down and firms find it cheaper to expand capacity and production, and so they ramp up investment spending. Push interest rates down and households find their balance sheets looking better and feel flush, expanding consumption spending.

There is one major complication: what Milton Friedman calls the "long and variable lags" in the system. Every action the Federal Reserve takes now affects production, demand and inflation roughly 15 months in the future. What the Federal Reserve has done in the past 15 months has not yet had a chance to affect the economy.

This leads to the Federal Reserve's current dilemma. The last two percentage points' worth of increases in interest rates -- increases in interest rates that will in the end make businesses cut back on investment spending and households feel pinched -- have not yet had a chance to affect the economy. Because of "long and variable lags," they are still "in the pipeline." When they emerge from the pipeline they will slow the economy further. By how much? Nobody is really sure.

In this situation it seems reasonable that the Federal Reserve should stop raising interest rates. Waiting to see what the interest-rate increases of the past couple of years will do to the economy would be a prudent strategy. Indeed, since last December the Federal Reserve has been quietly signaling that it is about to "pause," to adopt such a wait-and-see strategy. Yet so far it has not done so. Why not? One important reason is that the Federal Reserve is scared that if it pauses too soon it will convince many observers that it is not truly serious about fighting inflation -- and a central bank has a hard time fighting inflation if businesses, speculators and workers ever conclude that it is not truly serious.

The Federal Reserve is also unwilling to stop increasing interest rates because it is afraid of recession risk factor No. 2: a rise in oil and import prices. Those fears are justified. Remember how the invasion of Iraq, besides bringing a golden age of democracy to the Middle East, was also supposed to produce $15-dollar-per-barrel oil? Oil is now at $75 a barrel, and this rise in oil prices is putting upward pressure on prices in general. As for import prices, they are vulnerable to a U.S. dollar that has been weakened by the Bush budget deficit and massive borrowing from China. Suppose the dollar declines suddenly, which is not a far-fetched possibility. Should the dollar fall by, say, 30 percent, and should importers raise their dollar prices in proportion, then the one-sixth of U.S. spending that is spending on imports will see prices rise by 30 percent. Because 30 percent times one-sixth equals 5 percent, that would boost U.S. consumer prices by 5 percent nearly overnight.

Thus there are two big reasons for the Federal Reserve to keep raising interest rates, in spite of how much downward pressure on demand is still in the pipeline. The Federal Reserve thinks it needs to do so in order to establish its long-term credibility, and there are the twin dangers of oil- and import price-triggered inflation to guard against.

Most likely the Federal Reserve's continued raises in interest rates will not send the economy into recession. But there is that chance, and the chance is raised from a low-probability possibility to a serious worry by the third factor: that home-as-ATM problem. The unprecedented use of home loans to squeeze cash out of equity has allowed middle-class consumers to spend well beyond their means. Someday this spending spree has to come to an end. If it comes to an end suddenly, at a time when the Federal Reserve has raised interest rates a little too much, then we have our recession.

Make no mistake about it: The U.S. economy is close to the edge. Retail sales in the second quarter were rising at only a 2.1 percent annual pace. Business investment in equipment and software was falling. Residential construction was falling. Either households will continue spending beyond all reason, or businesses will start boosting investment, or exports will start booming, or there will be a recession sometime in the next year. Figure the odds at 3 out of 10.

What can be done to head off the danger? Unfortunately, very little. The bag of macroeconomic tricks is empty. In 2000-2001 the Federal Reserve could lower interest rates to the floor, boosting residential construction and consumer spending to offset the decline in high-tech investment, and turn the 2001 recession into a very small event indeed. In 2002-2003 the short-run stimulative effect of the Bush tax cuts came online at exactly the right moment to offset fears of a deflationary spiral. But today further fiscal stimulus would increase global imbalances -- meaning, raise the trade deficit -- and do more damage to confidence than it might do good in curing a recession. And sharp reductions in interest rates would lower the value of the dollar and increase inflationary pressures from import prices in a way that the Federal Reserve does not dare allow.

The past 24 years have been an amazing run as far as the business cycle is concerned. There have been only two recessions, and both of those were short and shallow. But Ben Bernanke and Co. are now at real risk of presiding over the third.

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