"Rate cutting will not get us out of this mess"

Wolfgang Munchau of the Financial Times provides an excellent and from what I can tell, overlooked argument against central banks’ eagerness to cut interest rates to shore up wobbly financial markets.

His point is simple, and I am annoyed that I didn’t think of it. The reason that monetary authorities are so quick to lower rates when a bubble bursts is that if an economy slips into deflation, it is very difficult to pull it out, as the last decade plus of stagnation attest. Yet as Munchau illustrates, there is no sign of a rapid fall in inflation, such as took place in Japan in the early 1990s and the US in the 1930s. Au contraire, inflation expectations are rising, particularly in Europe. That suggests that by using the wrong remedy, central bankers will merely be replacing one set of problems with another.

From the Financial Times:

“If stupidity got us into this mess, then why can’t it get us out?”
– Will Rogers, late US writer and actor

We are certainly trying very hard.

The stupidity that got us into our financial mess was low, and occasionally negative, real interest rates over long periods of time. Now that the bubble has burst, central banks are responding by cutting interest rates yet again.

By the end of this year, if market expectations prove correct, the US Federal Reserve will have cut short-term rates by a full percentage point from their peak. It has become the policy orthodoxy of the early 21st century that central banks must overreact to asset-price induced economic downturns.

This orthodoxy has its intellectual roots in past recessions. Burst asset price bubbles triggered the Great Depression in the 1930s and more recently cost Japan a decade of economic growth. What turned these crises into calamities was a string of policy mistakes. In both cases, central banks failed to respond to a sharp fall in inflation.

Once deflation descended on the US and Europe in the 1930s and on Japan in the 1990s, the zero nominal interest rate rendered monetary policy toothless: since nominal rates cannot go below zero, negative inflation implies positive real interest rates. In such an environment, central banks lose their ability to provide sufficient stimulus. The lesson the current generation of policymakers has drawn is that the monetary policy has to react fast and decisively when an asset-price bubble bursts and threatens a recession.

But that conclusion does not follow logically from historical observation. The mistake central banks made during those periods was to disregard a strong fall in inflation. It is our consensus today – and rightly so – that the ultimate purpose of monetary policy is to keep consumer price expectations anchored at some mildly positive inflation rate. Should those expectations fall dramatically, history has taught us that a central bank must act decisively to bring inflation back into target.

But we are living in a very different environment. On the contrary, inflation expectations are rising everywhere, and this is not a statistical argument about the price of oil and food. US core inflation has been above the central bank’s comfort level for some time. And in the eurozone, even a strong euro has not stopped inflation from rising to 3 per cent in November. This year’s price increases may fall out of next year’s inflation indices, but what about next year’s price increases? We are already seeing evidence of those dreaded second-round effects. Whether it is Finnish nurses or German train drivers, Europeans are asking for wage increases to compensate for a loss of purchasing power. Some of these negotiated wage increases are no longer consistent with the inflation target and productivity developments.

Just witness the furious debate on purchasing power that is raging in the French media. A perceived loss of purchasing power is often a first step towards a persistent increase in inflationary expectations. Long-term inflation expectations in the eurozone, as measured by interest rate futures, are running at nearly 2.5 per cent, which is not consistent with an official target of “close to but below 2 per cent”. While some forecasters expect eurozone inflation to slow next year, nobody predicts that it will fall below target, let alone turn negative.

So the inflation outlook would justify a neutral policy stance at best. I agree that there is a non-trivial risk of a substantial slowdown in the US economy and maybe even a recession. But it is not clear to me that monetary policy is the right tool to deal with a slowdown that is not accompanied or caused by a decline in inflationary expectations.

This is not a moral point. It is about what a central banker’s toolkit can realistically achieve. If a financial market generates a bubble, one would expect that asset prices would eventually fall back after the bubble has burst. Over long periods asset prices are self-correcting. If a central bank does not care about asset prices on the way up, but starts to target them on the way down, it risks stoking up inflationary expectations.

Look at it in terms of insurance. Lower interest rates insure us against the risk of a slowdown, but we are paying a price by accepting new risks. Among the biggest are moral hazard and higher inflation in the future.

The moral hazard argument is well known: banks reap the profits in the good times and beg for central bank support during bad times.

Higher inflation is a more immediate concern. If it is tolerated, expect serious convulsions in global bond markets and serious disruption to the global flows of funds. If it is not tolerated, expect a policy shift in the opposite direction and at greater magnitude. Neither scenario is appealing.

On balance, the benefits of a loose monetary policy are not nearly as one-sided as its advocates claim. A bias towards low interest rates got us into this mess. Low interest rates will not get us out of it. Central banks should keep their cool.

Print Friendly, PDF & Email


  1. jojo

    2/28 subprime ARMs will reset based on a spread above LIBOR of about 600 basis points, and Alt-A resets will reset based on a spread of about 300 – 400 basis points above LIBOR.

    The Fed could stop 2/28 resets by cutting the Fed funds rate down to 1.5%. However, since the Fed can’t set the nominal rate below zero, it is impossible for the Fed to cut rates low enough to prevent resets on 2/28 subprime ARMs and other subprime loans.

  2. Anonymous

    globalization makes independent monetary policies more difficult/less effective; uneven development within the global economy necessitates effective independent policies — that which becomes more necessary also becomes more difficult and less effective — national monetary policies ‘loose their punch’, are less able to control than the author seems to think the case,,,and, at an earlier time, even 20 years ago was.
    Concerted policy action becomes bogged in domestic and international tensions.
    The tendency is towards uncontrollability.

  3. Anonymous

    It’s a false argument – no sense of proportion. The last time I checked the Fed isn’t considering cutting rates to zero at the next meeting. There’s no sense of the marginal effect in this type of argument. This is the same type of thinking as those who say that cutting the funds rate won’t help the interbank market market because the problem lies in libor spreads. The all-in rate includes the funds rate the last time I checked. Do these people expect credit spreads to reverse out a fed cut? Makes a lot of sense. Higher credit spreads are tightening monetary policy without a fed cut. And the treasury market isn’t exactly telegraphing inflation risk.

  4. jojo

    I wanted to fix a typo.

    2/28 subprime ARMs will reset based on a spread above LIBOR of about 600 basis points, and Alt-A resets will reset based on a spread of about 300 – 400 basis points above LIBOR.

    The Fed could stop the average reset on Alt-A loans by cutting the Fed funds rate down to 1.5%. However, since the Fed can’t set the nominal rate below zero, it is impossible for the Fed to cut rates low enough to prevent resets on 2/28 subprime ARMs and other subprime loans.

  5. a

    “Higher credit spreads are tightening monetary policy without a fed cut.”

    I’d say exactly, or perhaps almost exactly, as I’d prefer: “Higher credit spreads are tightening monetary policy with or without a fed cut.” With all the predicted fed cuts, Libor 1Y USD is still at 4.43% and an effective rate (the rate that banks are really willing to let the money go, rather than what they say they are willing to let it go at) about 5 to 10 bips higher than that.

  6. Anonymous

    Where do you get money at the “all-in rate”?

    Are the markets that stupid that a mechanistic cut of rate will be pavolvian circa 1998?

    The problem is not rates. It is structural. Rate cutting misses the point completely, but it is the conventional solution and the Fed has no tother options. Lest we forget the gov’t is more exposed than enyone to the debt market (cornered dog).

    Spread widening is telling us nothing about rate cuts. it is telling us about risk/future and the fed cutting rates (from already historically low levels) will do nothing to retard the FUNDAMENTALS underlying the blow out in spreads.

  7. Anonymous

    maybe the fed isn’t so worried about the nominal 1m foreclosures or so (100 million hosueholds plus). maybe they don;t care about the dollar becasue they know they have no bullets left to protect it anyway. Maybe what they are really afraid of is a death spiral decline in the equity market which is papered over in household net wealth gains. make it so unnattractive to own debt (helps the fiscal side) that people are forced into equity damn the fundamentals. Globalization after all was sold on outr competitive advanateg in financial services after all.

  8. Anonymous

    Re: “If stupidity got us into this mess, then why can’t it get us out?”
    – Will Rogers, late US writer and actor

    We are certainly trying very hard.

    Re: In America’s ideal of freedom, citizens find the dignity and security of economic independence, instead of laboring on the edge of subsistence. This is the broader definition of liberty that motivated the Homestead Act, the Social Security Act, and the G.I. Bill of Rights. And now we will extend this vision by reforming great institutions to serve the needs of our time. To give every American a stake in the promise and future of our country, we will bring the highest standards to our schools, and build an ownership society. We will widen the ownership of homes and businesses, retirement savings and health insurance – preparing our people for the challenges of life in a free society. By making every citizen an agent of his or her own destiny, we will give our fellow Americans greater freedom from want and fear, and make our society more prosperous and just and equal. http://www.whitehouse.gov/inaugural/

  9. Anonymous

    Blackrock, et al (Paulson) are playing with fire!

    No Purchased
    Loan permits the release or substitution of collateral if such release or
    substitution (i) would create a “significant modification” of such Purchased
    Loan within the meaning of Treas. Reg. ss. 1.1001 3 or (ii) would cause such
    Purchased Loan not to be a “qualified mortgage” within the meaning of Section
    860G(a)(3) of the Code (without regard to clause (A)(i) or (A)(ii) thereof).

    Re: (vi) UCC Financing Statements for filing in each of the UCC Filing
    Jurisdictions described on Exhibit XIII hereto, each naming Seller as “Debtor”
    and Buyer as “Secured Party” and describing as “Collateral” all of the items set
    forth in the definition of Collateral and Purchased Items in this Agreement,
    together with any other documents necessary or requested by Buyer to perfect the
    security interests granted by Seller in favor of Buyer under this Agreement or
    any other Transaction Document;

    (vii) any documents relating to any Hedging Transactions;

    (viii) an opinion or opinions of outside counsel to Seller, substantially in
    the form of Exhibit XIV;

    Also: existing federal law penalizes homeowners who are able to restructure their mortgage and avoid losing their home by treating the amount they save through the new mortgage terms as “realized income.”

  10. Anonymous

    Not a student of economic theory so my idea is probably way off base but I can’t help but notice that money velocity world wide continues to slow and that debt service is now eating up a larger and larger % of available money supply. Back in 2005 total U.S. Real Estate transactions were 7.5 million in 2007 that number will probably be 2 million less and when you consider that this is occurring on a world wide basis that is a significant slow down in money velocity. Not surprised that we could have price inflation and deflation at the same time with critical commodities like food and fuel still in demand but RE and other leveraged financial products falling in demand as citizens and business spend more of their available capital on debt service.

  11. On-time bill payer

    Forgiven debt IS realized income. We can only hope that Congress & the IRS will continue to treat it that way.

  12. SReid

    Personally I think its of a simple minded argument

    The article is of the view that its just a bank problem. Unfortuantely the troubles will be passed on to customers – and on a global basis

    For example the article floating around where banks are telling people with facilities ‘not to borrow from us’. When was the last time you saw that?

  13. bob

    The new trend?

    Deutsche Bank Foreclosures Tossed Out of Ohio Federal Court – “They Own Nothing!”

    OLD NEWS. It’s been covered here already. It’s a lack of paperwork to prove ownership.

  14. Anonymous

    anon @ 12:49 PM,

    I agree that there’s simultaneity of rising and falling prices but, then, this is almost always the case — the overall trend and tendencies within it are of more importance.

    You very correctly mention food and fuel both of which, IIRC, have been rising more rapidly then prices-in-general. From this it may be helpful to recognize what’s most often ignored (and apparently often not acknowledged):

    Fuel price, to the extent that we’re talking about crude oils, has not been a free market supply/demand relation since a period during the later 19th century but was subject to combinations of monopoly, oligopoly and cartel pricing until essentially 1986 whereafter pricing has been primarily a function of on and off exchange futures markets.

    Very schmetically, there are a small number of marker crudes such as West Texas Intermediate/light sweet or Brent which other grades of crude oil are priced in reference too. The marker crudes’ prices are set not by arms length transaction in the physical but trade in paper barrels with the vast majority of these trades never taking, or intending to take, delivery.

    All of which is to say that prices were opened to speculative pressures able to drive beyond real economy fundamentals even as the pretense of efficient markets has been maintained, i.e. that futures prices must, by definition, be correct since this mechanism captures all current and expected real conditions.

    Academic papers galore have, by assuming what they intend to prove, efficiency, provided basis for this but – upon closer examination – most often ignore or set aside known problems with production/consumption data quality.

    Long story short, an abundance of money seeking higher than avg. returns moved into, and from moreless 2001, increasingly financialized commodity markets. While some memos in the trade have been specific about this, e.g. the influx from investors and expanded number and sizes of CTAs, commodity specific hedgies, etc, to include more retail ETFs and long only funds, it can nevertheless be seen through the lense of Nymex and weekly commitment of traders reports at the CFTC. The price of oils and a number of other commodities has a lot to do with large traders, specific leveraged financial products, and a lot less to do with the real economy that is generally portrayed.

Comments are closed.