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Half-Baked WSJ Op-Ed on the Fed

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I have spent the entire long weekend avoiding dealing with this article by David Ranson and Penny Russell, “Does the Fed Matter?” in Friday’s Wall Street Journal. The reason is that if I got going, there is so much in it that is off beam, misleading, or just plain wrong that it would be hard to know where to begin or end.

But I regard it as an important public service to point out the Journal’s foibles. The consensus opinion on the Journal is that its editorials are die-hard loyalist right wing, while the news pages are untainted (note we take issue with the perception of lack of news bias).

The op-ed articles live in a grey area. Most of them hew, predictably and closely, to the Journal’s editorial line. But some don’t. For example, I recall one actually saying nice things about Eliot Sptizer (admittedly compared to regulators) and another taking aim at 9 Fortune 500 companies that had promoted senior executives who had held only staff jobs to CEO over women who had had substantial, and successful, line experience.

And some are written by people of sufficient stature (and manage to steer clear of the Journal’s idee fixes) to be noteworthy in and of themselves. So I imagine many people look at the op-ed articles on a case-by-case basis.

The reason for dissecting this piece is that it makes a generally correct observation, namely, that the Fed is much less influential than it once was, which means that readers might be swayed by the authors’ assertion that the Fed’s impotence is a good thing.

But the logic they use to support their first observation, that the Fed’s powers are waning, is dubious:

Consumer spending grew at a healthy rate of 3.8% in real terms in the first quarter, despite the drop in overall GDP growth to 1.3%. Many on Wall Street find this a paradox: How can it be that consumer spending has been growing consistently at an unreduced rate in the past couple of years, while GDP growth fluctuates quarter to quarter? Shouldn’t they rise and fall together? Yet in fact, consumption has always moved more consistently from one period to another than GDP.

The relationship of this seeming paradox to the Fed’s relevance is this: It has been hiking interest rates between mid-2004 and mid-2006, meanwhile looking for the slowdown in consumer spending — and some relief from inflationary pressures — that it assumes will result. So far the lack of such a slowdown has put the Fed in a kind of no-man’s land: to hike or not to hike.

The presumption that the Fed’s policies are all about consumer spending is backwards. Yes, consumer spending now represents about 70% of the economy. But it hasn’t always been that important. Indeed, in the 1990s boom, technology spending was a big contributor to economic growth.

But the article really appears to be about this chart and its implications. We will grant that it is indeed an interesting chart, but not quite as central as the authors make it out to be (they both work for HC Wainwright).

Now if they had explained why this disconnect between Fed actions and consumer spending occurred, that would have been very useful. But correlation is not causation, and without some idea of what the causal link is, it is hard to reach any useful conclusions from this chart, save their top-line observation, that Fed interest rate hikes are less effective than before. They seek to draw a direct linkage (i.e., to find simple mechanism that no longer operate) when the story is likely pretty complex. For example, interest rate swaps were invented in the early 1980s but even by the early 1990s, banks were still structurally borrowing short and lending long, so when the Fed increased interest rates, it forced banks to increase their interest rates so they could maintain their margins.

The brave new world of finance is different in several respects. First, as we have noted before, banks and investment banks have increasingly structured their products to capture origination fees rather than interest spreads. And even in using their capital, they see themselves as traders rather than buy-and-hold investors.

The various swap markets are so deep (and bank assets are repackaged and tranched in dizzying ways) that banks have much more freedom to control the duration (finance speak for a notion that roughly approximates weighted average maturity) of their assets and liabilities. Thus, what happens on the short end of the yield curve just isn’t as determinative as it once was. That isn’t a story about consumers; it’s a story about how banking and the financial markets have changed.

But in an effort to prove their point, they develop a colorful fiction:

In the past the Fed was able to use various monetary mechanisms, including interest-rate pricing, to curb access to the credit markets. This would induce an economic slowdown as the business sector was forced to postpone growth and lay off employees. Sometimes it was more than enough to create a recession. But as the private-sector economy has grown, it has become more resilient. As a result of the globalization and increasing depth and reach of financial markets, interest-rate policy has become less and less effective at curbing the flow of capital. There has also been a kind of learning effect, as the business sector has gotten used to coping with credit-market uncertainties and the shock effect of interest-rate surprises has lessened….

Ready access to both equity and debt capital from a proliferating number of sources means that businesses are no longer forced to curtail their activities when the Fed impeded the banking system’s ability to provide credit. And since businesses thus no longer needed to lay off employees, employees no longer needed to cut back on their spending.

One would expect people who hold themselves as economists to have some respect for facts. But we see perilous little of that here.

One could just as easily say that the reason that we haven’t had a meaningful recession since the early 1990s isn’t the growth and adaptation of the private sector, but the growing gutlessness of the Fed. Greenspan, unlike his predecessors, wanted to be liked. Any time there was a serious slowdown or the threat of a market break (like the Thailand-Russia-LTCM crisis of 1997-1998, or the post 9/11 period), the Fed could be counted upon to flood the markets with liquidity (hence the expression, “the Greenspan put”).

Notice that this story is all about interest rates; it completely ignores the Fed’s other mechanism, money supply. Continuing high growth in broader measures of money (M3 here, M4 in the UK), are the big reason why the economy hasn’t slowed. It appears to be a combination of lack of interest (central bankers don’t watch money supply as closely as they once did) and greater difficulty (the mechanisms for staunching liquidity appear to be less effective than they once were).

Former Federal Reserve chairman William McChesney Martin defined the job of the Fed as taking away the punchbowl just when the party started getting good. It may be in this brave new world of finance that all the Fed can do is spike the punch.

Let’s continue parsing the piece:

Ready access to both equity and debt capital from a proliferating number of sources means that businesses are no longer forced to curtail their activities when the Fed impeded the banking system’s ability to provide credit.

Ahem, did this pair look at any data other than what went into their chart? Since 2004, large corporations, the sort that have access to the capital markets, have been net savers, an unprecedented development in a growing economy. They have been shrinking their companies, choosing to curtail their activities. Why? Mainly, to show better numbers to Wall Street. The shrinkage results from stock buybacks, curtailed investment, and cost (meaning headcount cutting).

As a result, the next part of their argument is clearly bogus:

And since businesses thus no longer needed to lay off employees, employees no longer needed to cut back on their spending.

Let’s name just a few companies that are cutting staff despite being profitable and enjoying a growing economy: IBM is about to start laying off 150,000 employees and will replace them with cheaper foreign hires. In 2005, after record profits, share buybacks, and handsome dividend payouts, and no black clouds on the horizon, Intel announced plans to get rid of 10,500 employees, roughly 10% of its staff. Citigroup will lay off 17,500 because their margins aren’t as good as their competitors.

These are not isolated cases. According to Bureau of Labor Statistics data, the average middle-aged male could expect to stay with his employer for 11 years. Now, he’s last only 7.5 years. And unemployment is longer: the average length of unemployment went from 13 weeks to 20 over the same timeframe. Yet the authors suggest that consumers happily keep on spending because employment has become more stable!

Mind you, this was the better part of the article. Let’s continue:

Every recession since 1945 has been attributable in large part to the credit squeeze produced by interest-rate hikes. In attempting to “cool off” an “overheated” economy, the Fed’s rate hikes in the past have killed off economic activity and inflicted pain on many sectors of society. To stop the spread of a disease (inflation) by killing the patient (the economy) is not a very productive way to proceed.

Again, nonsense or misleading or both. The terrible 1972-1973 recession was “largely” due to oil price shock. The 1980-1981 recession, admittedly nasty and very much a Fed creation, was seen as a triumph. Inflation had gotten so entrenched that it was impossible to produce meaningful financial statements (meaningful in an economic sense; those of you who are old enough to remember inflation accounting will know exactly what I mean), and the inability to understand where businesses truly stood had a crippling effect on investment and growth.

In the late 1980s, the Fed increased interest rates to staunch LBO lending, and that lending had become so profligate that its aftermath did considerable damage to the banking system (no, and the deals did not go bad due to the recession. Observers at the time agreed that some of the LBO companies were unsalvageable, and others were good companies that had been overleveraged). The recession of 1990-1991 was largely due to banks cutting lending because their capital bases were damaged. The Fed had started to cut rates in March of 1989. If the Fed hadn’t increased rates, the aftermath would have been worse. The only case where the Fed might stand guilty as charged is in the recession of 2000, but then again, that slowdown technically was not a recession (2 quarters of negative growth), so one could argue the Fed did a very good job of pricking the tech bubble without causing undue damage.

They digress into a discussion of the value of home equity loans in stabilizing consumer spending (eek!) and another whopper follows:

Widely disseminated predictions that the so-called housing “bubble” would collapse have deterred many home buyers, particularly those more interested in investment than simple shelter motives.

When we consider instead the price of the “median home,” we find that indices of home prices on a quality-adjusted basis, such as that published by the Office of Federal Housing Enterprise Oversight, were still showing no decline through the end of last year — merely a sharp deceleration in the gains. A reduction in the gain realized upon the sale of a home is not the same as a loss.

The Economist, among others, is the source of such predictions. And as we (and the Wall Street Journal on the day after this piece ran) have said, quality adjustment would make the fall in housing prices (and yes, Virginia, there has been a fall in average housing prices) even more pronounced.

The speciousness increases:

When we measure the price of homes in terms of an unstable unit such as the dollar, we are looking at only nominal gains, not real gains. Measured in terms of a stable measure of value such as gold, “real” house prices have been stable or declining throughout the last decade.

So let me get this straight: we are supposed to be happy because housing prices increased and that allowed consumers to continue to spend like drunkards despite stagnant wages and deteriorating job stability. But gee, we should take comfort in the fact that in gold terms, housing prices really haven’t gone up. If you buy that, that means consumers haven’t been spending their gains, they’ve been depleting their capital.

So to the final bit of alternative reality, Journal-style:

The data are telling us that consumer spending is continuing to grow without showing any sign of weakness. This is a happy conclusion, in spite of the heartburn it is giving to the Fed. It shows that nothing very bad is happening to the economy. As long as consumers experience stability or net gains in the equity value of their homes, and as long as unemployment remains low in the face of Fed tightening, consumers will have no difficulty maintaining the steadily rising stream of spending that is the underpinning of a healthy economy.

When I think of the disconnect between the declining trend of GDP growth and continued robust consumer spending, I get a different picture. Are you familiar with Road Runner cartoons? I see the image of Wile E. Coyote running off a cliff after Road Runner, suspended in air until he looks down.

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