naked capitalism

It appears the US central bank got taken to the woodshed at a conference hosted by the New York Fed for overly aggressive rate cuts, but despite jeering from the peanut gallery, it looks likely that the Fed will hold pat until at least the fall.

While I have no idea of how representative his view was, Willem Buiter was unabashedly critical of the US monetary authority at this gathering, and he evidently had company. From the abstract of the paper he presented:

…..since the excesses were confined mainly to the financial sector and, in the US and some European countries, the household sector, it should have been possible to limit the spillovers over from the crisis beyond the financial sector and the housing sector without macroeconomic heroics. Measures directly targeted at the liquidity crunch should have been sufficient. The macroeconomic response of the Fed to the crisis – 325 basis point worth of cuts between September 2007 and May 2008 and a 75 basis point cut in the discount window penalty – therefore seem excessive and create doubt about the Fed’s commitment to price stability.The liquidity-enhancing policies of the Fed, and its bailout of the investment bank Bear Stearns, were effective in dealing with the immediate crisis. They also were, quite unnecessarily, structured so as to maximise moral hazard by distorting private incentives in favour of excessively risky future borrowing and lending. The cuts in the discount rate penalty, the extraordinary arrangements for pricing the collateral offered to the Fed by the primary dealers through the TSLF and the PDCF, the proposals for bringing forward the payment of interest on bank reserves, the terms of the Bear Stearns bail out and the ‘Greenspan-Bernanke put’ rate cut on January 21/22 2008, 75 bps at an unscheduled meeting and out of normal hours, are most easily rationalised as excess sensitivity of the Fed to Wall Street concerns, reflecting (cognitive) regulatory capture of the Fed by Wall Street.

The evidence that Bernanke & Co. may have endured a bit of criticism is that Paul Krugman issued a defense in his New York Times column today (a buddy who saw Krugman speak at a conference of political bloggers felt that Krugman was unduly protective of his Princeton colleague Bernanke):

You might think, then, that everyone would be congratulating Mr. Bernanke and company for their good work. But at an economic conference I recently attended, many of the participants — including people with a lot of influence in the policy world — seemed to be bashing the Bernanke Fed.

Krugman’s arguments:

1. Avoiding a financial meltdown is more important than warding off price increases

2. There is no evidence that we are entering a 1970s-style wage-price inflation

The problem with this view is that it sees the US as more or less a closed system in a world of active international capital flows. Negative real interest rates in the US make it hard for trading partners suffering even worse inflation (China is a poster child) to take effective corrective measures. Raise rates, and what happens? You attract more hot money inflows, which are highly stimulative, and undercut the economic cooling you are trying to achieve. Of course, a measure that might have much the same impact without sucking in foreign funds would be for Çhina to drastically cut its high subsidies of fuel (gas costs roughly $1 a gallon). But that move would be highly regressive, so China may well resort to multiple measures rather than any one. And having a fair number of its trading partner raise rates (or at least be expected to increase them) would give the Chinese and others in the same boat a good deal more latitude.

And this stance wouldn’t simply for the benefit of emerging economies; emerging markets demand is seen as the main driver of high commodity prices; overly loose monetary policies (for those who believe that speculation plays a role) an additional driver.

Clive Crook, in the Financial Times, highlights the dilemma facing the Fed:

When a central bank has an uncomplicated recession to deal with, it can cut interest rates. When it faces a clear-cut case of inflation, it can raise them. The worst nightmare of any central banker – especially one with a tradition of political independence to defend – is stagflation, when raising interest rates to curb inflation will provoke a recession or deepen one that has already begun…

The economy sags under the combined weight of house price falls, consumer confidence at a 25-year low, the credit crunch and a still widening financial sector squeeze. Nonetheless, soaring prices for oil and other commodities, not to mention the higher cost of imports thanks to a devalued dollar, are pushing up inflation and (especially) expectations of inflation. Consumers appear to have capitulated to the rise in gasoline prices – hence indications of a marked shift away from thirsty sports utility vehicles to smaller cars. The problem is that once you assume that oil at $100 a barrel will be more than a brief aberration and start to change behaviour accordingly, you also begin to draw the implications for economy-wide inflation.

One of the principal reasons why the oil price spikes of the 1970s did such harm to output and employment was that expectations of high inflation were already entrenched. After oil prices had provided a big extra push, a recession was, in effect, required to break that psychology.

In the same way, if the oil price highs of 2006-08 have so far had remarkably mild effects, one likely reason is that inflation expectations at the outset were both low and well anchored – so that wages and other costs were not quickly bid up and inflation did not instantly rise to the top of the Fed’s list of concerns. If a new inflation psychology is now beginning to take root, the Fed might find itself in a world that is more like the 1970s than the one it has become accustomed to…

If the worst were over for output and employment, the Fed’s dilemma would be less painful – but that is most unlikely…On the most pessimistic assessments, the US is not even halfway to the bottom, despite the fact that house prices have already fallen 14 per cent in the year to the first quarter – a steeper rate of decline than seen during the worst year of the Great Depression.

Weigh this alongside the possibility, newly priced into the markets, that inflation will force the Fed to raise interest rates between now and the election. Coasting above that kind of turbulence really would be a challenge.

Tim Duy, University of Oregon Fedwatcher, gives a typically nuanced reading of the tea leaves (I recommend reading the entire post). and concludes despite the central bank’s new found hawkishness, it will probably stand pat until at least the fall. Key bits:

The Fed’s shift to a more hawkish stance in recent weeks has put an end to expectations of additional easing, shifting the debate to the timing of the inevitable rate hike. Nearly unrelenting questioning of the Fed’s commitment to price stability appears to be weighing on policy makers, even arch dove San Francisco President Janet Yellen….

The Fed, I suspect, will not entirely embrace Krugman’s position. The Fed is seeing the end of the tunnel with respect to the financial crisis (others, of course, see only the eye of the hurricane). And note the Fed will be wary of repeating their mistake in 1999 of failing to quickly reverse the emergency rate cuts of the previous fall. The TED spread fell to 80bp last week, well below the highs of over 200bp experienced during the height of the crisis. True, this could simply be a head fake; previous declines in the TED spread, such as that in February, proved to be short lived. Still, tolerance to risk appears to be returning to financial markets in general, and the 2-year Treasury has climbed to 2.65% while the 10-year broke the 4% mark last week – a signal that market participants are ready to accept a policy shift.

The Fed also views inflation expectations as uncomfortably fragile at this point….Dow Chemical’s decision to raise prices by as much as 20% will also be seen as a possible turning point in the inflation story as it signals limitations in trying to absorb steeply higher raw materials costs via lower margins or higher productivity. The Fed will be watching for signs that other producers are following suit.

Widespread price increases, however, would need to trigger corresponding wage increases to definitively lock in higher inflation expectations. On this front, the sluggish job market is clearly in the Fed’s favor….

Menzie Chen notes that per capita GDP growth has fallen into negative territory. Even though the pie is growing, the individual pieces are shrinking.

Abysmal readings on consumer confidence reflect those shrinking pie pieces, although the May decline appears excessive in some respects. Still, the high inflation expectations of 5.2% over the next year is weighing on consumers, and if expectations are indeed correct, we could see real consumption post a negative number for 2008 as a whole; the last such occurrence was in 1980….

The advance durable goods report offered the rare bright spot last week, with the non-defense, non-aircraft component up a sharp increase, continuing to run contrary to the recession story. Export strength is likely supporting new orders… This suggests that, for the time being, the external sector will likely continue to support the US economy somewhere near a sweet spot for the Fed, with enough strength to justify holding rates steady, but enough weakness to avoid raising rates even as inflation expectations climb.

Short Version: With some indications that the worst of the financial crisis is over, and rising inflation expectations becoming increasingly uncomfortable for policymakers, the Fed will hold policy constant through the summer. Rising bond yields – and the implication that fixed income traders will acquiesce to shift to stable policy – will provide comfort to policymakers. Barring clear evidence that inflation expectations are triggering widespread wage growth, the damaged economy will delay any rate hike until this fall at the earliest.

An immediate factor that will give the Fed the opportunity to wait and ponder the data further is that rates are rising on their own, reducing the pressure on the Fed to act. From the Financial Times:

US mortgage rates soared last week amid a sharp rise in Treasury market yields, as investors started to bet that inflation pressures could prompt the Federal Reserve to raise interest rates later this year.

The sell-off pushed rates on 30-year fixed-rate mortgages to an 11-week high of 6.02 per cent, up from 5.81 per cent a week earlier, according to Bankrate.com. Meanwhile, the so-called “jumbo” mortgages – or those for loans above $417,000 – rose to 7.21 per cent from 7.05 per cent.

This means that the borrowing rates on many home loans in expensive areas, such as California, Florida and New York, are now running at heights last seen in mid-April – or just before the government-backed mortgage financiers Fannie Mae and Freddie Mac began buying jumbo loans, in an attempt to support the market.

The surge in mortgage rates will make it more expensive to buy homes and less likely that existing homeowners will be able to refinance mortgages. That, in turn, is likely to damp hopes of an early recovery in the US housing market.

This story places the Fed’s dilemma in high relief: in can contend with inflation, or try to save the housing market, but not both. And since yours truly is of the view that the efforts to save housing will ultimately prove futile (home prices will have to correct to a level that is in line with buyer incomes), the sooner the central bank removes that element from its calculus, the better.