The Challenges Ahead for the Fed

This Bloomberg article highlights some of the challenges the Fed faces as it pushes real interest rates back into negative territory:

``The Fed is going to have to keep slashing rates, probably below inflation,'' said Robert Shiller, the Yale University economist who co-founded an index of house prices. ``We are starting to see a change in consumer psychology"... So-called negative real interest rates represent an emergency strategy by Chairman Ben S. Bernanke and are fraught with risks. The central bank would be skewing incentives toward spending, away from saving, typically leading to asset booms and busts that have to be dealt with later.

Negative real rates are ``a substantial danger zone to be in,'' said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed bank. ``The Fed's mistakes have been erring too much on the side of ease, creating circumstances where you had either excessive inflation, or a situation where there is an excessive boom that goes on too long.''

Read the whole thing

Real GDP Per Capita Shows Contraction, Not Slow Growth

Today we learn the U.S. economy weakened to 0.6% growth in the fourth quarter, a lower than expected growth rate according to CNBC and Bloomberg. What is not being reported, though, is that on a more meaningful per capita basis the U.S. economy outright contracted in the fourth quarter at a -0.4% rate. So as a public service, I am posting the below graph that shows the annualized growth rate of real GDP and real GDP per capita. The data comes from the BEA (I used their quarterly population data from the personal income tables).

To make sense of this decline in real GDP, I point you to the BEA table below which provides a nice decomposition of the real GDP growth rate. Here, each expenditure category's contribution to overall real GDP growth is reported. All the categories contributions sum to the real GDP growth rate.

Unsurprisingly, residential investment (circled in red) has been a drag all year. Another non-surprise given the decline of the dollar, is that net exports (also circled in red) have provided a net boost to real GDP since the second quarter. However, the contribution from net exports declined dramatically in the fourth quarter. Is this development of weakening global aggregate demand? The other interesting development to note in this table is the huge drag inventories had on real GDP in the fourth quarter.

Finally, below is the same table on an annual basis for the years 2004-2007. Here, you can see residential investment began to drag on the U.S. economy in 2006. Also, this table reveals that the boost from net exports appear to have come more from a decline in imports than from significant gains in exports.

Economic Cartoon Idea

Based on the discussion in my previous posting, I was thinking it would be great if some artist would draw a cartoon where Uncle Sam is in a cowboy hat pulling his two pistols out to shoot the recession outlaw. One pistol is labeled fiscal policy and the other one is labeled monetary policy. However, as Uncle Sam pulls the triggers he realizes he is out of ammunition in both guns. On the ground we see some empty shells with 'Bush budget deficits' and '2002-2005 low interest rate policy' written on them. You see panic set in on Uncle Sam's face as he realizes he is out of ammunition. I am hoping that some artist out there reads this request and draws up the cartoon. The artist can take full credit for the cartoon too. Just get me the picture so I can post it on my blog.

Update

Marmico in the comments sections points us to a hilarious cartoon that captures the spirit of my above posting:

Why Monetary Policy Has Already Used Up its Ammunition

The reality of a new fiscal stimulus package has led to much discussion about the proper type of fiscal stimulus during a recession (See here, here, and here). A key concern raised in this debate by some observers is that the past budget deficits under the Bush administration have used up of much of the ammunition fiscal policy would otherwise have had during a recession. Now The Economist makes a similar argument for why monetary policy stimulus may not be as effective this time around: it has used up much of its ammunition (i.e. monetary policy transmission channels) from being too loose and accommodative over the same time period.

"Faith in the Federal Reserve is not what it used to be. Since September the Fed has cut its policy rate by 1.75 percentage points, to 3.5%. It still has plenty of firepower left—rates are some way above the 1% level reached in 2003—but few seem willing to rely on monetary policy alone to save the day...

What lies behind this loss of faith? One cause is the feeling that overly loose monetary policy got the economy into this mess. Repeated cuts in interest rates during the last downturn, in 2001-03, fuelled the housing and credit bubbles that are now bursting to such damaging effect. The legacies of that boom—falling asset prices, high consumer debt and bank losses—may now hamper the ability of central banks to prop up spending."

Nicely put. Read the whole thing.

The Fed Apologist

One of the top monetary economists in the nation is seemingly bent on being a Fed apologist. Over at the WSJ Real Time Ecomics blog, Mark Gertler is defending the Fed's surprise interest cut last Tuesday. This is too bad, but not altogether surprising given his defense of the Fed's extremely loose monetary policy during the 2003-2005 period. Here is what he says regarding Tuesday's rate cut:

"... plans for significant easing was in the works before Tuesday. The global asset price decline certainly influenced the timing of the cuts, but I don’t believe it’s going to affect the medium term path of the Funds rate, which is going to be governed by events in the real economy."

So he admits global asset prices influenced the timing of the decision to cut rates. Does he not find this troubling? Since when is it in the Fed's mandate to respond to stock market movements? The only way to wiggle through that question is to reply (a) the stock market is harbinger of things to come in the real economy or (b) that the stock market decline itself will create real economic problems. He opts for the later:

"... [G]iven the weakened state of financial institutions, a sharp asset price contraction had the potential to significantly disrupt credit flows and thus do significant harm to the real economy. The Fed action offset this potentially disruptive chain of events."

Even if he is correct in this assessment, I see several new problems the Fed has created by this action. First, it sets a precedent for a 'Bernanke Put', similar to the 'Greenspan Put'. The market now knows that in the mind of the Fed it is too important to fail because of the potential real economic harm it may cause. Second, although Mark Gertler says the 'medium term path' of the fed funds rate has not changed because of this move I am less certain. The Fed's move last Tuesday set in play a whole new dynamic, as market expectations have now changed. How can Mark be so confident the 'medium term path' will now be the same? This is not a static world. Third, the Fed just used up a large chunk of their valuable ammunition on an uncertain outcome. Given the liquidity trap rumblings we now hear, this rate cut may be costly down the road. I may be wrong in my assessment, but for now the rate cut still appears to me as a panicked Fed responding to market volatility.

A New International Economics Book

I just received my copy of the new International Economics textbook by Robert Feenstra and Alan Taylor. My initial thoughts are that this book has the user friendly feel of introductory economic textbook but the substance of the Krugman & Obstfeld text. Most of my students in my international economics class are non-econ majors and they find the Krugman and Obstfeld text too dense. I am going to give this text a try in the Fall.

You can buy the book from Worth publishers either whole or broken down into its international trade and international macro sections. My dream is one day to have a international trade and an international macro course here instead of cramming them both into an one semester course. Should that day come, this text would be ideal.

The Economist and Benign Deflation

I had the privilege today of meeting Zanny Minton Beddoes, the economics editor for The Economist magazine. She was a presenter at at a regional economic outlook conference held in nearby Austin, Texas. Her part of the program was to deliver an assessment of the national economy. She did a great job describing the major shocks that have recently hit the U.S. economy--high oil prices, frozen credit markets, housing market bust--and the potential outcomes of these shocks. After her talk, I was able to chat with her for a few minutes. Among other things, I complemented her and The Economist for taking seriously the implications of benign deflation for the U.S. economy during the 2003-2005 period. As I have argued before, the Fed's misreading of the 2003 deflationary pressures as being malign when in fact they were benign led to an overly accommodative monetary policy at that time. As a consequence, interest rates were pushed far beneath their neutral level and the stage was set for the biggest housing boom-bust cycle in U.S. history. The Economist recognized this was happening and was one of the few observers sounding the alarm over this development (Andy Xie was another, see here). Only now are other observers (here, here) beginning to see how prescient The Economist was in its calls to reign in monetary policy during this time. It was a real treat, then, for me to meet Zanny, and briefly discuss these issues with her.

In case you missed The Economist's coverage of benign deflation and its implications for the U.S. economy during the 2003-2004 period, I have posted below an edited version of an article that appeared in 2004.

Inflated expectations
Jul 1st 2004

From The Economist print edition

A new paper questions whether inflation will really turn out to be America's main economic problem... Most commentators have cheered Alan Greenspan and his colleagues at the Fed for being so aggressive in warding off the deflationary threat caused by huge corporate debts and the popping of the stockmarket bubble... Mr King is not among those cheerleaders. He argues that the Fed was wrong to cut interest rates so much, because much of the deflationary pressure was of an altogether more benign sort: a reduction in overall prices caused by rapid technological change, improvements in the terms of trade and other factors. Britain had long periods of “good” deflation in the late 18th and 19th centuries, when nominal interest rates and growth were both strong. In recent years, argues Mr King, there has again been deflation of just that sort, and for similar reasons. Technological change and the integration of China, and increasingly India, into the global economy have pushed down the price of traded goods in America, thus pushing up real incomes. “And, because of these real gains, any rise in real debt levels will not be a source of potential ongoing instability,” writes Mr King. Alas, because the Fed's perceptions of deflation have been coloured by the experiences of America in the Depression and Japan in its lost decade, it reacted by reducing interest rates sharply, a response that is more likely to bring about the debt deflation it most feared.

High real growth—so long as deflation is of the good sort—requires high real interest rates. If rates are too low, people borrow too much and spend it badly: what Mr King calls “happy investment rather than good investment”. For a given level of nominal interest rates, a fall in prices will deliver the appropriate level of real interest rates. But by cutting nominal rates to prevent deflation, the Fed has reduced the real rate of interest too much.

Evidence that this has been the case comes in two forms. The first is that borrowing has ballooned in America in recent years. Any reduction in the indebtedness of American firms (under immense pressure from the capital markets) has been more than matched by borrowing by consumers and the government...

[T]he second piece of evidence [can be seen in] what Americans spend their money on. If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years. Companies have been slow to hire workers even as the economy has bounded along; and workers' share of national income is very low. The low cost of capital has, moreover, encouraged speculation in risky assets, such as emerging markets, or—closer to home, as it were—property. And, yes, with all that money sloshing about, it has also pushed up inflation a bit...

There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think—and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid.

If you want more, see Unnaturally low.